The instability of fixed exchange rate systems when raising the nominal interest rate is costly

This paper points to a vicious circle which may arise when a government tries to defend its currency by raising the nominal interest rate in a fixed exchange rate system. We present a stylised model in which raising the nominal interest rate helps to maintain the parity, but is costly for the government. The speculators are aware that this cost gives incentives for the government to stop defending the parity, which in turn reinforces the speculation against the currency. We show that this mechanism can generate self-fulfilling currency crises, the outcome of which depends on the level of sacrifice that the government is ready to endure and the evolution of domestic economic conditions. We provide some informal evidence showing that this model explains some features of the 1992-93 EMS crisis.