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 oftight
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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