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

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    Abstract

    The link between exchange rates and interest rates features prominently in the theoretical and empirical literature on small open economies. This paper revisits this relationship 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 also 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.ecb.europa.eu/pub/pdf/scpwps/ecbwp548.pdf
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    Bibliographic Info

    Paper provided by European Central Bank in its series Working Paper Series with number 548.

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    Length: 53 pages
    Date of creation: Nov 2005
    Date of revision:
    Handle: RePEc:ecb:ecbwps:20050548

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    Related research

    Keywords: Transmission mechanism; Emerging market economies; Exchange rate; Monetary policy.;

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    Cited by:
    1. Marcelo Sánchez, 2006. "How does information affect the comovement between interest rates and exchange rates?," Working Paper Series 608, European Central Bank.

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