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Monetary policy, default risk and the exchange rate

By Carlos Eduardo Soares Gonçalves and Bernardo Guimaraes

Abstract

In a country with high probability of default, higher interest rates may render the currency less attractive if sovereign default is costly. This paper develops that intuition in a simple model and estimates the effect of changes in interest rates on the exchange rate in Brazil using data from the dates surrounding the monetary policy committee meetings and the methodology of identification through heteroskedasticity. Indeed, we find that unexpected increases in interest rates tend to lead the Brazilian currency to depreciate. It follows that granting more independence to a central bank that focus solely on inflation is not always a free-lunch

Topics: HB Economic Theory
Publisher: Centre for Economic Policy Research
Year: 2007
OAI identifier: oai:eprints.lse.ac.uk:4762
Provided by: LSE Research Online
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