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

24 Pages Posted: 19 Jan 2007

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

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 optimising, 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 defence involves setting high interest rates (relative to the no defence case) both before and at the moment of the crisis.

Suggested Citation

Lahiri, Amartya and Vegh, Carlos A., Output Costs, Currency Crises and Interest Rate Defence of a Peg. Economic Journal, Vol. 117, No. 516, pp. 216-239, January 2007, Available at SSRN: https://ssrn.com/abstract=958123 or http://dx.doi.org/10.1111/j.1468-0297.2007.02008.x

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

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