Interest Rate Policy with Expectations of Devaluation

Abstract

The problem of recurrent devaluations in the Nordic countries is dealt with using a simple rational expec tations model. Given imperfect international asset substitutability a nd sufficient foreign exchange reserves, a small open economy can use interest rate policies geared to competitiveness to put an end to re current devaluations. If this policy is known and credible, no intere st rate adjustments are called for, except shortly before and during the expected devaluation phase. In contrast, a completely unanticipat ed interest rate policy requires that the rate of interest be raised continuously as the expected devaluation date is approached. Copyright 1988 by The editors of the Scandinavian Journal of Economics.