INTRODUCTION

For the countries most affected by the Asia crisis – Thailand, Indonesia, Malaysia, and Korea – economic events have been dramatic and have defied expectations. Exchange rates that had enjoyed a sustained period of stability depreciated precipitously. Between June 1997 and July 1998, nominal exchange rates vis–à–vis the U.S. dollar in Thailand, Indonesia, Malaysia, and Korea depreciated by about 67 percent, 500 percent, 40 percent, and 88 percent, respectively.

In response to these massive depreciations, the monetary authorities in these countries adopted tight monetary policies; specifically, they raised their short–term interest rates. After the implementation of the tight monetary policies, overnight call rates were raised from 15 percent to 22 percent in Thailand; from 10 percent to 47 percent in Indonesia; from 6 percent to 11 percent in Malaysia; and from 15 percent to 32 percent in Korea.

This chapter tries to answer the following basic question: Have the high interest rates had the desired effect of appreciating the nominal exchange rates in the crisis countries? It is well known that, in general, there is no stable empirical short–run relationship between exchange rates and interest rates (Frankel and Rose, 1995). Nominal exchange rates move as if they are a random walk (Meese and Rogoff, 1983). However, many policymakers believe, and anecdotal evidence suggests, that historically high interest rates have succeeded in stabilizing nominal exchange rates in some crisis countries, especially in Latin America.