Abstract
Abstract This paper describes the relationship between central bank interest rates and exchange rates under a capital control regime. Higher interest rates may strengthen the currency by inducing owners of local currency assets not to sell local currency offshore. There is also an effect that goes in the opposite direction: higher interest rates may increase the flow of interest income to foreigners through the current account, making the exchange rate fall. The historical financial crisis in Iceland provides excellent testing grounds for the analysis. Overall, the Icelandic experience does not suggest that cutting interest rates in small steps from a very high level is likely to make a currency depreciate significantly in a capital control regime, but it highlights the importance of effective enforcement of the controls.
Highlights
This paper describes the relationship between central bank interest rates and exchange rates under a capital control regime
How should an economy respond to a sudden stop of capital inflows? In particular, how should it combine the use of capital controls and high interest rates when attempting to stem capital outflows? The objective of this paper is to analyze the effect of interest rates in capital control regimes and explore the relationship using data from Iceland’s recent financial crisis
This paper has derived a relationship between central bank interest rates and exchange rates under a capital control regime
Summary
This paper describes the relationship between central bank interest rates and exchange rates under a capital control regime. Higher interest rates may strengthen the currency by inducing owners of local currency assets not to sell local currency off shore. There is an effect that goes in the opposite direction: higher interest rates may increase the flow of interest income to foreigners through the current account, making the exchange rate fall. The experience does not suggest that cutting interest rates moderately from a very high level is likely to make a currency depreciate in a capital control regime, but it highlights the importance of effective enforcement of the controls. JEL G01 E42 E52 E58 Keywords Financial crises; capital controls; policy rates; exchange rates Authors Gudmundur S.
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