Currency Boards When Interest Rates are Zero

17 Pages Posted: 20 Feb 2014

See all articles by David E. Cook

David E. Cook

Hong Kong University of Science & Technology (HKUST) - Department of Economics; Hong Kong University of Science & Technology (HKUST) - Department of Economics

James Yetman

Bank for International Settlements (BIS)

Date Written: February 2014

Abstract

In a fixed exchange rate system, any expectation that the peg may be abandoned will normally be reflected in an interest rate differential between instruments denominated in domestic and anchor currencies: the possibility of a revaluation will drive domestic interest rates below those in the anchor currency, for example. However, when interest rates are close to the zero lower bound, there is limited scope for exchange rate expectations to be reflected in interest rate differentials. Here we introduce a new mechanism, based on the central bank balance sheet, which works to bring about equilibrium in currency markets even when interest rates are zero. An expectation of exchange rate appreciation will cause foreign exchange reserves to swell, increasing the cost to policy‐makers of allowing an appreciation and, therefore, lowering the likelihood of the fixed exchange rate being abandoned. Under normal circumstances, this channel reinforces the equilibrating effect of interest rate differentials. When interest rates cannot adjust only this channel operates, implying that much larger changes in reserves are required to equilibrate currency markets. We develop a simple model to illustrate these arguments and find support for the predictions of the model using data for Hong Kong, the world's largest economy with a currency board.

Suggested Citation

Cook, David E. and Yetman, James, Currency Boards When Interest Rates are Zero (February 2014). Pacific Economic Review, Vol. 19, Issue 1, pp. 135-151, 2014, Available at SSRN: https://ssrn.com/abstract=2398675 or http://dx.doi.org/10.1111/1468-0106.12055

David E. Cook

Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China
2538 7614 (Phone)

Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China
2538 7614 (Phone)

James Yetman

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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