Do high interest rates defend currencies during speculative attacks? new evidence

Improving the measure of monetary policy

Kraay (2003) investigates the existence of non-linear effects of monetary policy. This paper extends on Kraay’s work and constructs an improved measure of monetary policy. It documents the most appropriate episode-specific indicator of monetary policy, experiments with alternative timings and introduces short-term debt as an additional factor that might affect the ability of monetary policy to defend a fixed exchange rate.

Policy recommendations include that:

a fundamental reconsideration of the role of monetary policy during speculative attacks is important
monetary policy tightening can only be used as a tool for crisis prevention in countries with relatively low corporate debt
if short-term debt is high, monetary policy will be ineffective and could even increase the probability that an attack results in a currency crisis
from a long-term perspective, strengthening the balance-sheet position of the corporate sector (i.e., limiting interest rate exposures) could be beneficial in reducing a country’s vulnerability to speculative attacks

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Do high interest rates defend currencies during speculative attacks? new evidence