Interest rate policy with expectations of devaluation

Abstract

The paper deals with the problem of repeated devaluations in the Nordic countries with the help of a simple rational expectations macroeconomic model. It is assumed that, after the latest devaluation, the private sector starts to expect a new future devaluation. With imperfect international asset substitutability, interest rate pegging and sufficient foreign exchange reserves, a small open economy reacts to an expected devaluation by a short-run expansion of output and an inflationary process which worsens price competitiveness and leads to a need to devalue. Interest rate policy geared to competitiveness can be used to put an end to the repeated devaluations. If this policy norm is known and credible, no interest rate adjustments are called for, except shortly before and during the expected devaluation phase. In contrast, a completely unanticipated interest rate policy demands that the rate of interest be raised continuously as the expected devaluation date is approached.