TY  - JOUR
AU  - Lahiri,Amartya
AU  - Vegh,Carlos A.
TI  - Output Costs, Currency Crises, and Interest Rate Defense of a Peg
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 11791
PY  - 2005
Y2  - November 2005
UR  - http://www.nber.org/papers/w11791
L1  - http://www.nber.org/papers/w11791.pdf
N1  - Author contact info:
Amartya Lahiri
Department of Economics
University of British Columbia
Vancouver, BC V6T 1Z1
Tel: 604-822-8606
E-Mail: alahiri@interchange.ubc.ca

Carlos A. Vegh
Department of Economics
Tydings Hall, Office 4118G
University of Maryland
College Park, MD 20742-7211
Tel: 301-405-3546
Fax: 301-405-3542
E-Mail: vegh@econ.bsos.umd.edu
AB  - 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.
ER  -