Currency Defences Should Not Raise Interest Rates Too Aggressively

When a currency comes under attack, central banks typically raise short-term interest rates to defend it. But new research by Professors Amartya Lahiri and Carlos Vegh suggests that while some defence of the currency may be optimal, too aggressive a policy may in fact prove to be too strong a medicine and make the patient even worse.

Their study, published in the January 2007 Economic Journal, examines whether defending a currency by raising interest rates is an effective policy. Economists widely disagree about this issue. Orthodox economists, such as those at the International Monetary Fund (IMF), would argue that, whatever the costs, achieving currency stability is a pre-condition for any further macroeconomic measures.

At the other end of the spectrum, high profile economists like Jeffrey Sachs and Joseph Stiglitz have argued vehemently against it and criticised the IMF for pushing for higher interest rates during the Asian crises of the late 1990s.

While higher interest rates should make domestic currency assets more attractive – and hence stop losses of international reserves under an exchange rate peg or prevent further depreciation under a more flexible exchange rate system – such a policy entails two main costs:

  • a fiscal cost: higher interest rates increase interest payments on the public debt;
  • and a cost of lost output from increased lending rates.

In a previous study, these researchers looked at the fiscal costs of raising interest rates to defend a peg/currency and concluded that while it is optimal for the central bank to engage in some defence of the currency, raising interest rates too much could actually be counterproductive.

In this new study, they reach a similar conclusion regarding the output costs of higher interest rates. An increase in interest rates makes domestic currency assets more attractive (what they call the ”money demand effect”) but causes a contraction of output as a result of an increase in lending rates.

The research shows that the money demand effect prevails for small increases in interest rates and hence that it is optimal to engage in some interest rate defence. Beyond a certain point, however, the output contraction that results from further increases in interest rates causes a reduction in the demand for domestic assets that dominates the money demand effect.

As a result, higher interest rates will be counterproductive and may in effect precipitate the crisis that they were trying to prevent.

”Output Costs, Currency Crises and Interest Rate Defence of a Peg” by Amartya Lahiri and Carlos Vegh is published in the January 2007 issue of the Economic Journal.

Carlos Végh

001-310-825-7371 | cvegh@ucla.edu

Amartya Lahiri

University of British Columbia