The Interest Rate-Exchange Nexus in Currency Crisis By Gabriela Basurto and Atish Gosh

1. The Interest Rate-Exchange Nexus in Currency Crisis By Gabriela Basurto and Atish Gosh Presented by Kelli Mayes

2. East Asia Crisis • Indonesia, Korea, and Thialand • Controversial element of stabilization program was the stance of monetary policy and the strict tightening that accompanied it • Depreciation of the exchange rate after stabilization programs raised doubts

3. East Asia Crisis • High (presumably real) interest rats, by causing widespread bankruptcies ( or the expectation thereof), result in larger country risk premiums-so much so that the expected return to investors actually declines as interest rates increase, thus promoting even more capital flight and generating greater downward pressure on the exchange rate

4. Tighter Monetary Policy • Measuring how an increase in nominal interest rates appreciates or depreciates the currency can be a difficult task • Previous approaches have run into problems

5. Previous Problems • The level of interest rate is simply not a good measure of monetary stance • In January 1998 interest rates in Indonesia reached almost 60% per year at a time when the money supply was expanding at a monthly rate of 30%

6. Previous Problems • Simple time series correlations or vector autoregressions provide very little structure on the model, and their empirical performance in explaining exchange rate movements is limited • Hard to determine what is the driving exchange rate when model does not explain it

7. Proposed Alternative Approach • As the relative price of two monies, the exchange rate should appreciate in response to a contraction of the domestic money supply • In East Asia Crisis countries have better correspondence between the exchange rate and interest rates

8. Proposed Alternative Approach • Standard monetary model may be useful for explaining the bulk of the exchange rate dynamics • Isolated risk premiums allow for a direct test of whether higher real interest rates are associated with a larger risk premium and downward pressure on the exchange rate

9. Methodology • Calculate the benchmark exchange rate based on a pure monetary model that abstracts from any (non-constant) risk premium • Benchmark exchange rate captures the risk premium • Correlated to explanatory variables

10. Methodology • If high real interest rates are expected to cause widespread bankruptcies and cause downward pressure on the exchange rate they should positively correlate with the risk premium

11. Model • The model consists of three basic building blocks. Real money demand is assumed to depend positively on income and negatively on the nominal interest rate: 10 m – p = αy – βi

12. Where m is the log of money, p, the log of the domestic price index, y, the log of output, and i, the domestic interest rate. • Finally, the real exchange rate is given by vt = pt + p*t – st.

13. Empirical Results • Broad money is used as monetary aggregate and part of the expansion of the money supply may be endogenous to the exchange rate because of foreign currency deposits • Addressed by removal of the valuations effect of the stock of foreign exchange deposits on the money supply

14. Empirical Results • Choice of sample period is a problem and consequently Basurto and Gosh proceed by reporting results for the period 1990: Q1-2000:Q6 and for the post float-period

15. Results • The pure monetary model seems to characterize movements of the exchange rates reasonably well, and it provides a credible framework to control for the direct impact of monetary aggregates on the exchange rate • It is also clear that the risk premium was not constant

16. Determinants of Risk Premium • Many factors account for the widening risk premiums as the crisis deepened in each country • Part of the widening risk premiums may be correlated to higher real interest rates

17. Conclusions • Nominal interest rates are not a good gauge of the monetary stance-particularly in a crisis environment, where the nominal interest more likely reflects fears of inflation and of currency depreciation-and propose a method of testing whether higher real interest rates indeed contributed to a weakening of currency

18. Conclusions • Little evidence that higher real interest rates contributed to a widening premium and to a weakening of the exchange rate • The authors conclude that the perverse effect of higher interest rates on the exchange rate remains largely a theoretical curiosus