In this paper, we argue that there may be a contradiction in the use of nominal interest rates to defend a parity in a fixed exchange rate system. The essential reason is that raising the nominal interest rate does not only help to maintain the parity; it may also be costly for the economy. Foreign exchange market participants are aware that this cost creates incentives for the government to stop defending the parity, which in turn increases their expectations of devaluation. This makes possible vicious circles in which the nominal interest rate and the probability of devaluation grow together, until the cost becomes too large and devaluation actually occurs. We show that fixed exchange rate systems are vulnerable to this type of self-fulfilling currency crisis under very general conditions.
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