Sharp Increase in Interest Rate as a Signal of the Resolve to Defend Currencies

There is little if any research that explicitly models or tests the positive effects of temporary high interest rates as a signal of the resolve of a central banker to maintain or strengthen the value of the currency. Does an increase in interest rate defend the value of a currency? A (one-shot) sharp increase does. In this paper, we start with a game-theoretical model in which a monetary authority increases the interest rate and wins a reputation of being strong. The speculators are thus stopped from continuing the attack. The model is a variant of the reputation game that originates from the discussion of market signalling. As with other models of credible policies, the reputation of being strong hinges on the significant costs incurred to the monetary authority. Unlike the existing models of currency defence, we consider some general opportunity costs of foregone investments, and the depletion of foreign reserves is not a necessary ingredient. Speculators infer the unknown type of the monetary authority solely from high interest rates. This signalling mechanism applies well to reserves-abundant economies, where other interest-sensitive fundamentals are more relevant. Finally, we provide evidence to show that the model is consistent with the events in some emerging market amidst the Asian crisis.