This paper reviews some models of central bank intervention in the foreign exchange market
in the context of tight monetary policy. It is shown that in a small open economy with capital
mobility it is still possible to raise the domestic interest rate, at least temporarily, above the
international one if the domestic price level exhibits some rigidity (the “overshooting
hypothesis”) or if domestic and foreign bonds are imperfect substitutes. The increase in the
domestic interest rate in the context of tight money often involves an increase in the risk
premium as a result of the change in the asset portfolio of the public. The risk premium can be
derived by using the capital asset pricing model of finance theory. Some illustrations of the
change in portfolio are presented using the Israeli experience. The paper concludes with a
discussion of diffusing the risk premium in a successful disinflation.
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