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When do exchange rate defenses fail?: the role of economic signals and political considerations during currency crises

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Theoretical and empirical research yields ambiguous results about the influence of high interest rates and other factors on the outcome of speculative attacks. I present a two-period signaling game that models the dynamics of an exchange rate defense and derive hypotheses about the impact of several political and institutional variables on the outcomes of crises. I then test the model’s empirical implications using data on speculative attacks in OECD countries during the post-Bretton Woods era. The estimation results from duration and selection models show that, contrary to the empirical findings by previous studies, raising interest rates decreases the hazard that the peg collapses during six months after the attack. The main exception is the crisis in Sweden in 1992 when the government raised interest rates to extraordinary levels and then devalued. Governments devalue more often in the aftermath of elections. Central bank independence decreases the hazard that the peg collapses.

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en

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http://eprints.lse.ac.uk/43239/

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