Delaying the Inevitable: Optimal Interest Rate Policy and Bop Crises

56 Pages Posted: 21 Jun 2000

See all articles by Amartya Lahiri

Amartya Lahiri

University of British Columbia (UBC) - Department of Economics

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS); University of Maryland - Department of Economics; University of California at Los Angeles; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: April 2000

Abstract

The classical model of balance of payments crises implicitly assumes that the central bank sits passively as international reserves dwindle. In practice, however, central banks typically defend pegs aggressively by raising short-term interest rates. This paper analyzes the feasibility and optimality of raising interest rates to delay a potential BOP crisis. Interest rate policy works through two distinct channels. By raising demand for domestic interest-bearing liquid assets, higher interest rates tend to delay the crisis. Higher interest rates, however, increase public debt service and imply higher future inflation, which tends to bring forward the crisis. We show that, under certain conditions, it is feasible to delay the crisis, but raising interest rates beyond a certain point may actually hasten the crisis. A similar non-monotonic relationship emerges between welfare and the increase in interest rates. It is thus optimal to engage in some active interest rate defense but only up to a certain point. In fact, there is a whole range of interest rate increases for which it is feasible to delay the crisis but not optimal to do so.

JEL Classification: F41, E52

Suggested Citation

Lahiri, Amartya and Vegh, Carlos A., Delaying the Inevitable: Optimal Interest Rate Policy and Bop Crises (April 2000). Available at SSRN: https://ssrn.com/abstract=228707 or http://dx.doi.org/10.2139/ssrn.228707

Amartya Lahiri

University of British Columbia (UBC) - Department of Economics ( email )

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HOME PAGE: http://www.econ.ubc.ca/alahiri/

Carlos A. Vegh (Contact Author)

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS) ( email )

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Washington, DC 20036-1984
United States

University of Maryland - Department of Economics ( email )

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University of California at Los Angeles ( email )

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310-825-9528 (Fax)

HOME PAGE: http://vegh.sscnet.ucla.edu

National Bureau of Economic Research (NBER)

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