TY  - JOUR
AU  - Lahiri,Amartya
AU  - Vegh,Carlos A.
TI  - Delaying the Inevitable: Optimal Interest Rate Policy and BOP Crises
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 7734
PY  - 2000
Y2  - June 2000
UR  - http://www.nber.org/papers/w7734
L1  - http://www.nber.org/papers/w7734.pdf
N1  - Author contact info:
Amartya Lahiri
Department of Economics
University of British Columbia
Vancouver, BC V6T 1Z1
Tel: 604-822-8606
E-Mail: amartyalahiri@gmail.com

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  - The classical model of balance of payments crises implicitly assumes that the central bank sits passively as international reserves dwindle.  In practice, however, central banks typically defend pegs aggressively by raising short-term interest rates. This paper analyzes the feasibility and optimality of raising interest rates to delay a potential BOP crisis.  Interest rate policy works through two distinct channels. By raising demand for domestic, interest-bearing liquid assets, higher interest rates tend to delay the crisis.  Higher interest rates, however, increase public debt service and imply higher future inflation, which tends to bring forward the crisis.  We show that, under certain conditions, it is feasible to delay the crisis, but raising interest rates beyond a certain point may actually hasten the crisis. A similar non-monotonic relationship emerges between welfare and the increase in interest rates.  It is thus optimal to engage in some active interest rate defense but only up to a certain point.  In fact, there is a whole range of interest rate increases for which it is feasible to delay the crisis but not optimal to do so.
ER  -