# Capital flight and interest rates

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?

• 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. – Dan Nov 29 '18 at 15:28
• You are right- only the central bank can influence the money supply. Thanks! – ChinG Nov 29 '18 at 17:25

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.