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How raising interest rates can cause inflation and currency depreciation

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  • Jón Helgi Egilsson

Abstract

In this paper we derive a new model on exchange rate response to a lasting higher interest rate level. Contemporary models do not provide a convincing explanation for this relationship, but recent research suggests that models based on demand-pull effects to be somewhat confined to small funding cost increases. This would make cost-push effects more relevant when the interest rate differential (IRD) is larger and longer-lasting. The new model accounts for cost-push effects and suggests that a persistent higher IRD can evoke multiple responses, including currency depreciation, specialization, inflation, and wage drift. The model suggests that excessive long-lasting IRD can spark a chronic interaction between inflation and currency depreciation. Empirical data substantiate the prediction capability of the new model. We also demonstrate how the uncovered interest rate parity (UIP) principle is a special case, which can explain its empirical research anomalies, and when carry trade is a profitable investment strategy.

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  • Jón Helgi Egilsson, 2020. "How raising interest rates can cause inflation and currency depreciation," Journal of Applied Economics, Taylor & Francis Journals, vol. 23(1), pages 450-468, January.
    • Handle: RePEc:taf:recsxx:v:23:y:2020:i:1:p:450-468
    DOI: 10.1080/15140326.2020.1795526
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    1. Prasada, Imade Yoga & Nugroho, Agus Dwi & Lakner, Zoltan, 2022. "Impact of the FLEGT license on Indonesian plywood competitiveness in the European Union," Forest Policy and Economics, Elsevier, vol. 144(C).

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