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The link between interest rates and exchange rates: do contractionary depreciations make a difference?

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  • Marcelo Sanchez
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    Abstract

    This paper revisits the relationship between interest rates and exchange rates using a simple model that incorporates the role of exchange rate pass-through into domestic prices and distinguishes between cases of expansionary and contractionary depreciations. The model results show that the correlation between exchange rates and interest rates, conditional on an adverse risk premium shock, is negative for expansionary depreciations and positive for contractionary ones. For this type of shock, interest rates are found to be raised to prevent the contractionary effect of a depreciation regardless of whether the latter effect is strong or mild. Interest rates are predicted to eventually rise in response to an adverse net export shock in contractionary depreciation cases, and to be lowered in the case of expansionary ones.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/10168730801898981
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal International Economic Journal.

    Volume (Year): 22 (2008)
    Issue (Month): 1 ()
    Pages: 43-61

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    Handle: RePEc:taf:intecj:v:22:y:2008:i:1:p:43-61

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    Web page: http://www.tandfonline.com/RIEJ20

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    Related research

    Keywords: transmission mechanism; emerging market economies; exchange rate; monetary policy;

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    Cited by:
    1. Sánchez, Marcelo, 2010. "Modelling anti-inflationary monetary targeting: with an application to Romania," Working Paper Series 1186, European Central Bank.
    2. Sánchez, Marcelo, 2009. "Characterising the inflation targeting regime in South Korea," Working Paper Series 1004, European Central Bank.
    3. Sánchez, Marcelo, 2008. "Monetary stabilisation in a currency union of small open economies," Working Paper Series 0927, European Central Bank.

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