A Simple Test of the Effect of Interest Rate Defense

34 Pages Posted: 27 Oct 2006 Last revised: 28 Mar 2007

See all articles by Allan Drazen

Allan Drazen

University of Maryland - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Stefan Hubrich

T.Rowe Price

Date Written: October 2006

Abstract

High interest rates to defend the exchange rate signal that a government is committed to fixed exchange rates, but may also signal weak fundamentals. We test the effectiveness of the interest rate defense by disaggregating into the effects on future interest rates differentials, expectations of future exchange rates, and risk premia. While much previous empirical work has been inconclusive due to offsetting effects, tests that "disaggregate" the effects provide significant information. Raising overnight interest rates strengthens the exchange rate over the short-term, but also leads to an expected depreciation at a horizon of a year and longer and an increase in the risk premium, consistent with the argument that it also signals weak fundamentals.

Suggested Citation

Drazen, Allan and Hubrich, Stefan, A Simple Test of the Effect of Interest Rate Defense (October 2006). NBER Working Paper No. w12616. Available at SSRN: https://ssrn.com/abstract=938409

Allan Drazen (Contact Author)

University of Maryland - Department of Economics ( email )

College Park, MD 20742-1815
United States
301-405-3477 (Phone)
301-405-7835 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Stefan Hubrich

T.Rowe Price ( email )

100 East Pratt Street
Baltimore, MD 21202
United States
410.345.2169 (Phone)

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