Speculative Runs on Interest Rate PegsThe Frictionless Case
and Christopher Phelan
In this paper we show that
interest rate rules
lead to multiple equilibria when the centralbank faces a limit to its ability to print money, or when private agents are limited in theamount of bonds that can be pledged to the central bank in exchange for money. Some of the equilibria are familiar and common to the environments where limits to money growthare not considered. However, new equilibria emerge, where money growth and inﬂationare higher. These equilibria involve a run on the central bank’s interest target: householdsborrow as much as possible from the central bank, and the shadow interest rate in theprivate market is diﬀerent from the policy target.
Until the last couple of years, most central banks around the world conducted monetary policyby setting targets for short-term interest rates, and letting the quantity of money adjust inresponse to demand. Maneuvering interest rates as a way to achieve low and stable inﬂation isnow regarded as a success story. Yet this was not always the case. As mentioned by Sargent ,
For valuable suggestions, we thank Fernando Alvarez, Gadi Barlevy, Robert Barsky, Mariacristina De Nardi,Robert E. Lucas, Jr., and Thomas J. Sargent. The views expressed herein are those of the authors and notnecessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System.
Federal Reserve Bank of Chicago
University of Minnesota and Federal Reserve Bank of Minneapolis