THE INSTABILITY OF FIXED EXCHANGE-RATE SYSTEMS WHEN RAISING THE NOMINAL INTEREST-RATE IS COSTLY

This paper points to a vicious circle which may arise when a governmen t tries to defend its currency by raising the nominal interest rate in a fixed exchange rate system. We present a stylised model in which ra ising the nominal interest rate helps to maintain the parity, but is c ostly for the government. The speculators are aware that this cost giv es incentives for the government to stop defending the parity, which i n turn reinforces the speculation against the currency. We show that t his mechanism can generate self-fulfilling currency crises, the outcom e of which depends on the level of sacrifice that the government is re ady to endure and the evolution of domestic economic conditions. We pr ovide some informal evidence showing that this model explains some fea tures of the 1992-93 EMS crisis.