Fighting Inflation with High Interest Rates: The Small Open Economy Case under Flexible Prices

In high inflation countries, policymakers often end up paying interest on part of the money supply. Higher interest rates on money have been used both to reduce inflation and to defend the domestic currency. This paper analyzes the effectiveness of such a policy in the context of an open economy with flexible prices and exchange rates. A temporary increase in the interest rate on money reduces the price level on impact but inflation follows an explosive path afterwards. The domestic currency appreciates on impact but begins to depreciate immediately thereafter. Hence, the analysis does not support the use of high interest rates in disinflationary programs. (Printed by permission of the publisher.)