Interest Defense of a Fixed Exchange Rate

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Interest Defense of a Fixed Exchange Rate

• From Flood and Jeanne

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Mbase-money, SExchange rate, slnS, mlnM,
Bworld-wide private holding of domestic
government debt blnB, Rinternational reserves,
DCB domestic credit idomestic-currency
interest, iforeign-currency interest
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Noutstanding domestic nominal government bonds
i(N-D)net interest payment of consolidated
government, ST government deficit, i
SRinterest payments on international reserves
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If teta0, anticipated attack tack place when
shadow exchange rate equals fixed exchange rate,
and domestic credit grows at the same rate g
before and after the attack
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The wedge in the interest parity condition gives
the authorities an additional degree of freedom
in setting the interest rate
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Assume that interest rate is constant before and
after the attack but can jump at the time of the
attack
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The pre-collapse regime the monetary authority
intervenes in the domestic bond market and in the
foreign exchange market to fix prices. Asset
market equilibrium is
Foreign reserves move to clear the market
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Debt dynamics
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Pre-collapse debt path
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Post-collapse debt path
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Increasing i requires a fully sterilizing
balancing reserve outflow to accommodate the
private portfolio shift at a fixed exchange
rate. Increasing i induces a different balancing
operation. The monetary authority purchases
international reserves but more than fully
sterilized in order to accommodate reduced money
demand.
Dynamics of R are determined by the dynamics of
N. At the attack time, R jumps to preserve
asset market equilibrium and to avoid exchange
rate jump.
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Pre-collapse debt dynamics are
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Post-collapse regime the economy settles
immediately into real steady state with constant
rate of depreciation, nominal expansion and a
constant real level of government debt. Since T
is constant, and seignorage is determined by the
new level of i, the only remaining balancing
variable is the real level of debt nN/S
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but
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The Shadow exchange rate at time t is the
value of the exchange rate such that
Is proportional to the state variable
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The collapse is inevitable if nominal debt N
explodes. The collapse is essentially a
reflection of fiscal imbalance. It is always
possible to raise T so as to prevent the
explosion of N. it can be shown that
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Raising the interest rate before the attack or
lowering it after the attack hastens the
collapse. Intuition raising the interest rate
before the attack worsen the fiscal imbalance,
since it amounts to financing a stock of
low-interest-rate-bearing foreign assets by
borrowing at a high interest rate. A higher
nominal interest rate is then reflected one-to-one
in a higher real rate of interest since the
exchange rate and prices are fixed. On the other
hand, higher interest rate after the collapse are
associated with higher seigniorage revenues,
allowing the government to service a larger real
debt in the steady state. After the collapse an
increase in the nominal rate of interest has no
bearing on the real rate of interest. But, by
raising the inflation rate it raises the
seigniorage revenue.