Delaying the Inevitable: Interest Rate Defense and Balance of Payments Crises

Posted: 4 Apr 2003

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)

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 nonmonotonic 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.

Suggested Citation

Lahiri, Amartya and Vegh, Carlos A., Delaying the Inevitable: Interest Rate Defense and Balance of Payments Crises. Available at SSRN: https://ssrn.com/abstract=384224

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 )

College Park, MD 20742
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University of California at Los Angeles ( email )

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United States
310-825-7371 (Phone)
310-825-9528 (Fax)

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

National Bureau of Economic Research (NBER)

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