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)| false Lane, Timothy, Ghosh, Atish, Hamann, Javier, Phillips, Stevens, Schulze-Ghattas, Marianne, and Tsidi Tsikata, 1999, “ IMF-Supported Programs in Indonesia, Korea, and Tailand, A Preliminary Assessment,” Occasional Paper No.178 ( Washington: International Monetary Fund).
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This paper benefited from comments by seminar participants at the IMF, UCSC, UC Berkeley and by Michael Dooley, Peter Garber, Nancy Marion, Richard Portes and Andrew Rose.
Our justification for a wedge in UIP is the assumption that domestic and foreign–currency bonds are imperfect substitutes in agents’ portfolios. At a deeper level, imperfect substitution may reflect a utility-based bias toward own-currency assets that could be derived from those assets having a liquidity advantage over foreign-currency assets (see Lahiri and Végh, 1999). The wedge could equally well result from increasing marginal domestic-currency borrowing cost (see Drazen, 1999). The function we use here is derived from risk aversion in Jeanne and Rose (1999). In the first version of this paper we used a formulation, derived from Flood and Marion (2000), where the wedge was proportional to the ratio of domestic bonds to foreign bonds in investors’ portfolio—and we obtained similar results.
Holding τ constant is a simplification that allows us to divorce asset-market effects of interest rate policy from associated fiscal reform.
This is because the standard KFG model is deterministic. Stochastic extensions of this model, such as in the second part of Flood and Garber (1984b) or Obstfeld (1986), produce a peso effect before the collapse. In these models, however, UIP holds. The interest rate differential remains the passive reflection of devaluation expectations, not the result of an active interest rate defense.
This statement assumes (1/θ) + ∂m/∂r > 0, which ensures that increasing r raises the net demand for domestic-currency denominated assets.
This is where we rule out post-collapse hyperinflationary bubbles and government Ponzi schemes. Without ruling out such anomalies, the timing of collapse is arbitrary. See the appendix for details and see Flood and Garber (1984b) for a discussion of this issue.
In this sense the model is in the spirit of the fiscal extensions of the KFG framework, see e.g. Buiter (1987). Daniel (2000) recasts the argument in the context of Woodford’s (1995) “fiscal theory of the price level.” Our argument is indebted especially to Sargent and Wallace (1981).
In our constant interest rate assumption we have allowed simplicity to preclude the optimal interest rate policy—the one that would maximize the length of the fixed rate epoch. The optimal policy minimizes pre-attack debt accumulation subject to R* ≥ 0 with the post attack interest rate set to maximize seignorage.
Such an effect was at work in Brazil in 1998, according to some commentators.
This type of multiplicity was pointed out in Flood and Garber (1984a) following comments made by Steven Salant. Obstfeld (1986) pioneered using the idea in the exchange rate context where it has had a large following; see Flood and Marion (1999) for a survey.
The value of 1 for the interest rate semi-elasticity of money demand is in line with estimates obtained in the literature (Cuthbertson and Galindo, 1999). Parameter θ is the increase in the domestic interest rate that is required to attract one unit of foreign capital. Its calibration is based on Werner’s (1996) finding that in the two years leading to the 1994 Mexican peso crisis, increasing the share of peso-denominated debt (CETES) in total debt (CETES+TESOBONOS) required a 0.25 percentage point increase in the interest rate on one-month CETES. In 1992-93 total debt (CETES+TESOBONOS) amounted to approximately 20 US$ bn and Ml to approximately 40 US$ bn. Hence the dollar reserves attracted by a 1 percentage point rise in the one-month peso interest rate can be estimated to 4 percent of total debt, or 2 percent of Ml, implying 1%=θ 2% μ, or θ=1/(2μ).
This section has benefited from discussions with Michael Dooley, Peter Garber and Nancy Marion.
To keep the analysis simple, we have not studied the possibility of temporary interest rate responses to temporary shocks. The model is well-suited to such an investigation, but at the price of algebraic complexity.