Optimum interest rate for a country under a floating exchange rate system

Abstract

Analyzed are Phillips curves for the two exchange rate systems; fixed and floating exchange rate systems. Short- and long-run curves for both systems are compared and it is found that the country who prefers to inflate less than the world tends to adopt the floating exchange rate system. When we consider the interest-induced international capital flows, the Phillips curve for a country under the floating exchange rate system shifts down as the short-term interest rate increases. This is beneficial to the economy while the higher interest rate brings costs; interest payments to foreigners, and less economic growth if the long-term rate is raised accordingly. By equalizing the marginal benefit and marginal cost of the higher interest rate policy, we can find the optimum interest rate. Empirically, we found that the Japanese optimum rate was 14.1%, the long-term rate being kept constant. The cost of lower economic growth was prohibitive to allow the long-term rate to increase. The best we could suggest was to raise the short-term interest rate as high as possible until it reaches 14.1% while keeping the long-term rate intact.