Delaying the Inevitable: Optimal Interest Rate Policy and BOP Crises

Abstract

, the World Bank, and Yale for helpful comments and discussions. We gratefully acknowledge research support provided by grants from the UCLA Academic Senate. We are also indebted to Alejandro Jara for superb research assistance and Bernando Blum for providing us data on Brazil. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

Twin dollarization and exchange rate policy

“…This imperfect financial market also implies that there might exist an interest rate differential between the domestic interest rate and the world interest rate even when exchange rates are fixed. For example, seeLahiri and Vegh (2003). Introducing a foreign bond market would likely lower the variability of domestic interest rates, thus reducing the cost of borrowing in the local currency.…”

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

“…Hence, it is always optimal to engage in some active interest rate defence, contrary to the implicit assumption in most of the literature based on Krugman (1979). In conjunction with our previous work (Lahiri and Végh, 2003), where we abstracted from output costs and focused solely on fiscal costs, the results of this article suggest cause for extreme caution and restraint in the use of higher interest rates as an instrument for defending exchange rate pegs.…”

“…It bears repeating, however, that there are alternative ways of introducing imperfect asset substitutability which preserve the monetary authority's ability to influence domestic interest rates. Thus, introducing a liquidity service from domestic bonds, as in Calvo and Végh (1995) and Lahiri and Végh (2003), or a costly banking technology for managing domestic assets, as in Edwards and Végh (1997), would also introduce an endogenous wedge between the foreign and domestic interest rates. The effectiveness of interest rate policy then resides in the ability of the central bank to influence the wedge by an appropriate choice of policy.…”

“…Raising the interest rate on this domestic bond increases both the lending rate to firms as well as the deposit rate paid to depositors. The latter effect increases money demand (defined as the Drazen (2003), Flood and Jeanne (2005) and Lahiri and Végh (2003). Empirically, the evidence on the effectiveness of higher interest rates in defending/strengthening the domestic currency is mixed (see, for example, Dekle et al (2001) and Kraay (2003)).…”

Sovereign default and the sustainability risk premium effect

“…The bdebt overhangQ problem identified by Krugman is similar to the decrease in the demand for government bonds that we examine here. Finally, Lahiri and Vegh (2000) find a range of interest rates for which central banks can successfully defend currency pegs. However, in contrast to our approach, those authors study riskless interest rate policies for a liquid domestic asset in a classical balance-of-payments crisis model.…”