Interest Rate Defenses of Currency Pegs

36 Pages Posted: 15 Feb 2006

See all articles by Juan A. Solé

Juan A. Solé

International Monetary Fund (IMF)

Date Written: May 2004

Abstract

This paper studies a policy often used to defend a currency peg: raising short-term interest rates. The rationale for this policy is to stem demand for foreign reserves. Yet, this mechanism is absent from most monetary models. This paper develops a general equilibrium model with asset market frictions where this policy can be effective. The friction I emphasize is the same as in Lucas (1990): money is required for asset transactions. When the government raises domestic interest rates, agents want to increase their holdings of domestic currency in order to acquire more domestic-currency-denominated assets. Thus, agents do not run on the reserves of the central bank, and the peg survives. A key implication of the model is that an interest rate defense can always be successful, but at great costs for domestic agents. Hence the reluctance of governments to sustain this policy for long periods of time.

Keywords: Interest rates, exchange rates, currency crises

JEL Classification: E58, F31, F41

Suggested Citation

Sole, Juan A., Interest Rate Defenses of Currency Pegs (May 2004). IMF Working Paper, Vol. , pp. 1-36, 2004. Available at SSRN: https://ssrn.com/abstract=878908

Juan A. Sole (Contact Author)

International Monetary Fund (IMF) ( email )

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