NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

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

Amartya Lahiri, Carlos A. Vegh

NBER Working Paper No. 11791
Issued in November 2005
NBER Program(s):   IFM

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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Document Object Identifier (DOI): 10.3386/w11791

Published: Amartya Lahiri & Carlos A. VĂ©gh, 2007. "Output Costs, Currency Crises and Interest Rate Defence of a Peg," Economic Journal, Royal Economic Society, vol. 117(516), pages 216-239, 01. citation courtesy of

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