risk premium questions

A couple of people have asked me similar questions that I'm not sure I
wanted to spend a lot of time on tommorow but that others would probably
find interesting.

< In class we talked about how monetary policy had no discretion when
< interest rates are fixed (they essentially have to follow the lead of the
< country you are fixing to). But we also talked about Argentina (or Brazil?,
< I don't have my notes with me) fixing to the dollar, but that interest rates
< were still higher because of the risk factor. Can you explain a bit more
< about how those two coexist?

also.....

< 1. What is the difference between pegging your currency versus having a
< fixed exchange rate? I assumed they were the same and that the only option
< available to countries that pegged/fixed exchange rates was to
< devalue/revalue their currency in specific situations - but NOT have the
< ability to change interest rates since their currency is fixed But time &
< againg, you read (in the FT) about countries (with pegged/fixed systems)
< making a trade-off between changing interest rates (which I understood was
< not allowed) or devalue/revalue their currency. Also, does the presence of
< a currency board versus having a central bank make a difference? This is
< especially confusing in understanding the effects of Argentina peggin to the
< dollar and it's impact......

First pegged exchange rates are the same as fixed exchange rate. A
currency board goes further by promising by law that you will not change
the fixed rate (ie devalue).

In reality, r = r* does not hold perfectly. It is a simplification
which we use to explain why under a fixed exchange rate system monetary
policy is inneffective...that there would be infinite capital flows to
the country with a higher interest rate. I would read through Mankiw p
315 to 318 for a discussion on the risk premium which addresses your
question.

Now, the situations you refer to where a country chooses between
devaluation or raising interest rates occurs because a country is
drawing down its foreign reserves and despite the fat that r = r*, money
is flowing out. You can think of this as the introduction of a risk
premium, theta. So that r = r* + theta. So r must now be raised in
order to preserve the capital flow equilibrium.

Without foreign reserves the central bank cannot honor the fixed
exchange rate. Its choices then are either to raise the interest rates
sharply to preserve the currency or to devalue thereby raising net
exports and making it more expensive for foreigners to sell the domestic
currency (ie pesos) for dollars. In the Mexico example in Mankiw, the
country did not raise rates and was eventually forced to devalue.

Often the idea is that a country should take the step to devalue before
it is in a crisis situation if it is not willing to cause a recession to
keep the exchange rate fixed. This is what the IMF advised the Asian
countries months before the crisis. They did not want to because of
credibility issues and fears that devaluing itself might precipitate a
crisis and raise the risk premium. The problem is that if you wait too
long it becomes a fate accompli.

A currency is advocated by some because it replaces the central bank
with "a cash register" and solves the credibility issue. The main
drawback is that you may have to cause a recession to honor your
exchange rate.