Output Costs, Currency Crises, and Interest Rate Defense of a Peg

41 Pages Posted: 24 Feb 2006 Last revised: 21 Sep 2010

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)

Date Written: November 2005

Abstract

Central banks typically raise short-term interest rates to defend currency pegs. Higher interest rates, however, often lead to a credit crunch and an output contraction. We model this trade-off in an optimizing, first-generation model in which the crisis may be delayed but is ultimately inevitable. We show that higher interest rates may delay the crisis, but raising interest rates beyond a certain point may actually bring forward the crisis due to the large negative output effect. The optimal interest rate defense involves setting high interest rates (relative to the no defense case) both before and at the moment of the crisis. Furthermore, while the crisis could be delayed even further, it is not optimal to do so.

Suggested Citation

Lahiri, Amartya and Vegh, Carlos A., Output Costs, Currency Crises, and Interest Rate Defense of a Peg (November 2005). NBER Working Paper No. w11791, Available at SSRN: https://ssrn.com/abstract=851700

Amartya Lahiri (Contact Author)

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Carlos A. Vegh

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

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University of Maryland - Department of Economics ( email )

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