Output Costs, Currency Crises, and Interest Rate Defense of a Peg / Amartya Lahiri, Carlos A. Vegh.

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Lahiri, Amartya

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Material type: Text

TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w11791.Publication details: Cambridge, Mass. National Bureau of Economic Research 2005.Description: 1 online resource: illustrations (black and white)Subject(s):

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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.

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Previous	nber w11789 Paternalism and Psychology /	nber w1179 Public Sector Labor Markets /	nber w11790 Does Hazardous Waste Matter? Evidence from the Housing Market and the Superfund Program /	nber w11791 Output Costs, Currency Crises, and Interest Rate Defense of a Peg /	nber w11792 Establishing Credibility: Evolving Perceptions of the European Central Bank /	nber w11793 An Analysis of the Impact of Affirmative Action Programs on Self-Employment in the Construction Industry /	nber w11794 The Effect of Randomized School Admissions on Voter Participation /	Next

November 2005.

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.