Academic journal article I.D.E. Occasional Papers Series

2: The Asian Currency Crisis and IMF High Interest Rate Policy: A Critical Reconsideration Using a Dynamic Model

Academic journal article I.D.E. Occasional Papers Series

2: The Asian Currency Crisis and IMF High Interest Rate Policy: A Critical Reconsideration Using a Dynamic Model

Article excerpt

I. Introduction

There has been a great deal of criticism voiced against the International Monetary Fund's prescription for dealing with the Asian currency crisis. Radelet and Sachs (1998) argued that the closure of banks in Indonesia in November 1997 brought on investor panic which worsened the crisis. Feldstein (1998) argued that the incorporating of structural reform policies with conditionality was inappropriate for dealing with the short-term liquidity crisis. Rodrick (1998) and Bhagwati (1998) called into question the IMF's intention of liberalizing capital transactions. Bhagwati also criticized the powerful influence on the IMF of the close relationship between the U.S. Treasury Department and Wall Street financial institutions through their exchange of personnel, what Bhagwati calls "a Wall Street-Treasury complex," which has had a significant influence on the formulation of IMF policies. Even the World Bank (1998), the IMF's "Bretton Woods sister institution," has discreetly criticized the failure of IMF policies to cope with the Asian crisis. Noteworthy in this criticism has been the reference to monetary policies, attesting to doubts among many about the effectiveness of IMF intentions to maintain stable exchange rates through high interest rate policies.

The IMF (1999) itself came to acknowledge some of these criticisms. It admitted that at the start of the Asian currency crisis it miscalculated the severity of the crisis, and that its excessively tight fiscal policy had been inappropriate. However, it did not waver in its attitude that high interest rates were needed to stabilize exchange rates, and it maintained this attitude even in the face of the Brazilian currency crisis at the start of 1999 when international investors were expecting a cut in interest rates; the IMF instead insisted that Brazil raise interest rates.

Joseph Stiglitz (2002), formerly of the World Bank, sharply criticized the way the IMF dealt with the Asian currency crisis, saying in part that following the crisis it should have stimulated the affected economies. In reaction to this criticism, the IMF made a frank admission there had been mistakes in its policy in the aftermath of the crisis, with the exception of its high interest rate policy. Thus despite such admission, and the need for "honest debate and a closer look at the evidence" (Dawson 2002), the IMF's basic stance of "restoring external confidence by raising interest rates" (ibid.) continues unchanged.

Thus the correctness of high interest rate policy remains an important issue in the debate surrounding the IMF's prescription for curing the Asian currency crisis. Kashiwabara and Kunimine (1999) examined the issue and came to four conclusions: (1) high interest rates worsened the crisis in domestic financial systems, (2) stimulating capital inflow through high interest rates increases the probability of future instability in capital flows, (3) high interest rates are inappropriate as an anti-inflation measure, and (4) alternatives to high interest rate policies should be considered.

All the above criticisms point out the serious side effects of high interest rate policies. But none look into whether or not these policies are effective in maintaining exchange rates, which of course is the original intent of such policies. This study seeks to clarify this issue. In so doing, it will undertake a theoretical examination using a dynamic model of exchange rates. There is a problem however. The IMF has not clearly defined what sort of model its own theoretical model is. This seems to be due to the fact that the IMF has always been too confident of its high interest rate policy.

Up to now the IMF has been satisfied with the simple explanation that "high interest rates restore investor confidence in the currency." Therefore it has not shown much interest in presenting a more deeply penetrating theoretical model. Recently it has provided a roughly sketched model in IMF (1999). …

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