Monetary Policy, Default Risk and the Exchange Rate

20 Pages Posted: 5 Jun 2008

See all articles by Bernardo Guimarães

Bernardo Guimarães

London School of Economics & Political Science (LSE) - Department of Economics

Carlos Eduardo Soares Gonçalves

Universidade de São Paulo - USP

Date Written: October 2007

Abstract

In a country with high probability of default, higher interest rates may render the currency less attractive if sovereign default is costly. This paper develops that intuition in a simple model and estimates the effect of changes in interest rates on the exchange rate in Brazil using data from the dates surrounding the monetary policy committee meetings and the methodology of identification through heteroskedasticity. Indeed, we find that unexpected increases in interest rates tend to lead the Brazilian currency to depreciate. It follows that granting more independence to a central bank that focus solely on inflation is not always a free-lunch.

Keywords: default, exchange rate, identification through heteroskedasticity, monetary policy

JEL Classification: E5, F3

Suggested Citation

Guimarães, Bernardo and Soares Gonçalves, Carlos Eduardo, Monetary Policy, Default Risk and the Exchange Rate (October 2007). CEPR Discussion Paper No. DP6501, Available at SSRN: https://ssrn.com/abstract=1140028

Bernardo Guimarães (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 (0)20 7955 7502 (Phone)

HOME PAGE: http://personal.lse.ac.uk/guimarae

Carlos Eduardo Soares Gonçalves

Universidade de São Paulo - USP ( email )

São Paulo SP, 05508-900
Brazil
551130916062 (Phone)

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