This paper uses a simple open economy interest rate determination model to empirically examine an important aspect of pre-crisis monetary and exchange rate policy. It investigates whether sterilization of the reserve effects of capital inflows helped keep interest rates sufficiently high that they may have prolonged the inflow of capital. Despite the use of a pre-crisis sample in this study, the issues in this paper have relevance today given the recent trend in foreign capital inflow for Asia. The empirical section is concerned with the effect of reserve flows on the interest rate and is divided into two parts. The first tests for a contemporaneous effect of the basic model using OLS and IV methods. The second generalizes the model to assess for lagged effects by way of VAR analysis. The results show that there are some contemporaneous effects of sterilization on the domestic interest rate though the effects are stronger when estimating the lagged model.

JEL classification:F30, F32, F41