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A double-edged sword. High interest rates in capital-control regimes

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  • Gylfi Zoega
Abstract
This paper derives the relationship between central bank interest rates and exchange rates under a capital control regime. Higher interest rate may strengthen the currency by reducing consumption and imports and by inducing foreign owners of local currency assets not to sell local currency off shore. There is also an effect that goes in the opposite direction: Higher interest rates increase the flow of interest income to foreigners through the current account which makes the exchange rate fall. The historical financial crisis now under way in Iceland provides excellent testing grounds for the analysis. Overall, 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 highlights the importance of effective enforcing of the controls.

Suggested Citation

  • Gylfi Zoega, 2009. "A double-edged sword. High interest rates in capital-control regimes," Economics wp47, Department of Economics, Central bank of Iceland.
    • Handle: RePEc:ice:wpaper:wp47
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    More about this item

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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