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I am currently reviewing some stuff on capital flight and self-fulfilling crises.

In this scenario, investors generally think that a low availability of reserves could imply that the central bank may not be able to hold a fixed exchange rate. Consequently, investors quickly convert their domestic assets into foreign assets.

Given that this implies that the money supply decreases (as currency in circulation reduces), shouldn't this automatically increase interest rates? (Under IS-LM framework, a decrease in money supply increases interest rates). As a result, domestic assets should automatically become more valuable, thus fixing the problem naturally. Is there a problem in this line of reasoning?

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    $\begingroup$ If investors are selling domestic assets in private markets, then these assets don't disappear, they're bought by someone else. So I'm not sure about your assumption that the domestic money supply will fall. $\endgroup$ – Dan Nov 29 '18 at 15:28
  • $\begingroup$ You are right- only the central bank can influence the money supply. Thanks! $\endgroup$ – ChinG Nov 29 '18 at 17:25
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It is very difficult for interest rates to cover the losses caused by a sharp devaluation. For example, if you believe that a currency is going to drop to 75% of its current value within 3 months month due to a devaluation, you need an annual interest rate of about 216% ($3.16^{\frac{1}{4}} \approx 1.33 \approx \frac{1}{0.75}$) to cover that loss.

Since interest rates of that magnitude would cause deep stress for domestic borrowers, we can reach a point where speculators believe that the central bank will not raise interest rates by enough to cover the losses (relative to a foreign currency) created by a devaluation.

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As a result, domestic assets should automatically become more valuable, thus fixing the problem naturally. Is there a problem in this line of reasoning?

The main point here is that domestic assets are not positively correlated with the domestic interest rate. Other than that, there are "forces" in opposite directions that make it impossible to "mechanically" predict the net outcome of variables from which crises are determined.

For instance, when investors convert their domestic assets to foreign assets, they are dumping domestic currency, thereby causing its depreciation and a lower "cost" (return) for borrowing (lending) money. From that standpoint, this is akin to a decrease of domestic interest rate.

On the other hand, the central bank would need to offer a higher interest rate in order to lure lenders into purchasing bonds. Also cheaper domestic assets might become attractive to foreign investors. It is just impossible to outline where the equilibrium rate will be, let alone to identify a priori its sufficiency for fixing a crisis.

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