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

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  • Sánchez, Marcelo

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. JEL Classification: E52, E58, F31, F41

Suggested Citation

  • Sánchez, Marcelo, 2005. "The link between interest rates and exchange rates: do contractionary depreciations make a difference?," Working Paper Series 548, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2005548
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    Cited by:

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    3. Jakub Bureš, 2017. "Herding Behaviour of Central Banks: Following the Fed and ECB," European Journal of Business Science and Technology, Mendel University in Brno, Faculty of Business and Economics, vol. 3(1), pages 21-28.
    4. Yang, Sheng-Ping, 2017. "Exchange rate dynamics and stock prices in small open economies: Evidence from Asia-Pacific countries," Pacific-Basin Finance Journal, Elsevier, vol. 46(PB), pages 337-354.
    5. Gheorghe MOROSAN & Ioana Madalina ZUBAS, 2015. "Interest Rate, Exchange Rate And Inflation In Romania. Correlates And Interconnection," Journal of Public Administration, Finance and Law, Alexandru Ioan Cuza University, Faculty of Economics and Business Administration, vol. 8(8), pages 146-160, December.

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    More about this item

    Keywords

    emerging market economies; exchange rate; monetary policy; transmission mechanism;
    All these keywords.

    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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