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IAI Actuarial Core Principles · Business Economics · Recent macroeconomic history

During the 1997-98 Asian crisis, a country with a fixed exchange rate faced heavy capital outflows. If its central bank raised domestic interest rates sharply to defend the currency, what was a main cost of this policy?

The main cost was that higher interest rates raised borrowing costs for firms and banks already under strain, increasing defaults and non-performing loans and slowing output. Defending the peg this way supported the currency but deepened the domestic recession.

  1. AHigher borrowing costs weakened firms and banks and slowed outputCorrect
  2. BLower unemployment as investment surged
  3. CA rise in the real value of foreign-currency debt was avoided entirely
  4. DImmediate growth in tax revenue from higher profits
  5. A fall in the cost of servicing domestic loans

Explanation

Raising rates attracts capital and supports the currency, but raises debt-service costs for domestic borrowers, worsening bankruptcies and non-performing loans and reducing output. The other options describe benefits that do not follow from tight policy during a crisis.

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