NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

A Simple Test of the Effect of Interest Rate Defense

Allan Drazen, Stefan Hubrich

NBER Working Paper No. 12616
Issued in October 2006
NBER Program(s):   DAE   IFM

High interest rates to defend the exchange rate signal that a government is committed to fixed exchange rates, but may also signal weak fundamentals. We test the effectiveness of the interest rate defense by disaggregating into the effects on future interest rates differentials, expectations of future exchange rates, and risk premia. While much previous empirical work has been inconclusive due to offsetting effects, tests that "disaggregate" the effects provide significant information. Raising overnight interest rates strengthens the exchange rate over the short-term, but also leads to an expected depreciation at a horizon of a year and longer and an increase in the risk premium, consistent with the argument that it also signals weak fundamentals.

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Document Object Identifier (DOI): 10.3386/w12616

Published: Drazen, Allan & Hubrich, Stefan, 2006. "A simple test of the effect of interest rate defense," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 612-636, December.

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