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

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Author Info
Marcelo Sánchez () (Correspondence to: European Central Bank, Postfach 160319, 60066 Frankfurt am Main, Germany)
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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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.;

Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
F31 - International Economics - - International Finance - - - Foreign Exchange
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Marcelo Sánchez, 2006. "How does information affect the comovement between interest rates and exchange rates?," Working Paper Series 608, European Central Bank. [Downloadable!]
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