Interest-rate and borrowing defense against speculative attack

Abstract

Our understanding of defense against speculative attacks on fixed exchange rates is incomplete. Though interest rates are often raised to defend a currency, there is almost no formal modeling of interest-rate defense. We present a framework of analysis with special emphasis on signaling when there is incomplete information about the central bank's ability or commitment to defend the fixed exchange rate. The primary focus is on why a high-interest-rate defense may fail even if it raises the cost of speculation and hence temporarily deters speculation. It is shown that the effect of high interest rates under asymmetric information very much depends on the information structure, and hence on the signal that high interest rates send. Depending on what is known, high interest rates may either deter or fuel further speculation. The analysis should be useful in understanding the mixed empirical results on the effectiveness of the interest-rate defense in practice.