High interest rates to defend the exchange rate signal that a government is committed to fixed exchange rates, but may also signal weak fundamentals. We test the effectiveness of the interest rate defense by disaggregating into the effects on future interest rates differentials, expectations of future exchange rates, and risk premia. While much previous empirical work has been inconclusive due to offsetting effects, tests that 'disaggregate' the effects provide significant information.
Mixed Signals in Defending the Exchange Rate: What do the Data Say?Allan Drazen and Stefan Hubrich ,
CEPR Discussion Paper No. 4050