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Effectiveness of high interest rate policy on exchange rates A reexamination of the Asian financial crisis.pdf

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Effectiveness of high interest rate policy on exchange rates A reexamination of the Asian financial crisis.pdf

EFFECTIVENESS OF HIGH INTEREST RATE POLICY ON EXCHANGE RATES: A REEXAMINATION OF THE ASIAN FINANCIAL CRISIS TIM BRAILSFORD, JACK H. W. PENM, AND CHIN DIEW LAI Received 25 December 2005; Revised 29 June 2006; Accepted 30 June 2006 One of the most controversial issues in the aftermath of the Asian ﬁnancial crisis has been the appropriate response of monetary policy to a sharp decline in the value of some currencies. In this paper, we empirically examine the eﬀects on Asian exchange rates of sharply higher interest rates during the Asian ﬁnancial crisis. Taking account of the cur- rency contagion eﬀect, our results indicate that sharply higher interest rates helped to support the exchange rates of South Korea, the Philippines, and Thailand. For Malaysia, no signiﬁcant causal relation is found from the rate of interest to exchange rates, as the authorities in Malaysia did not actively adopt a high interest rate policy to defend the currency. Copyright © 2006 Tim Brailsford et al. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. 1. Introduction Many countries at the centre of the Asian ﬁnancial crisis adopted a high interest rate policy in an attempt to defend their currencies. This action is consistent with the tradi- tional view in which tight monetary policy is believed to be necessary for supporting a currency, as higher interest rates increase the return for investing in a country and hence reduce capital outﬂows, and discourage speculative attacks on the currency concerned. However, many economists have argued a revisionist view. They believe that when balance of payment crises occur simultaneously with ﬁnancial crises, as is the case of the Asian ﬁnancial crisis, a tightening of monetary policy may be counter productive. This is because, they argue, sharply higher interes