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On the Relationship Between Exchange Rates and Interest Rates: Evidence from the Southern Cone

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  • Ansgar Belke
  • Kai Geisslreither

    ()

  • Daniel Gros

    ()

Abstract

The purpose of this paper is to provide a closer view on the interaction of exchange rate volatility and interest rate volatility in the Mercosur countries. We discuss several models that explain systematic correlations between the movements of both variables and their second statistical moments, i.e. their volatilities. In contrast to the “fear of floating” argument that could lead to a volatility trade-off, we argue that both variables are largely driven either by the credibility of a country or by politics in general and thus should move in the same direction. Subsequently, we test this hypothesis of a positive correlation between both variables empirically. As a final step, we control for the impact of third variables such as exchange rate misalignment, financial stress, and monetary volatility. Our results show that – independent from third variables –there is a notable co-movement of exchange rates and interest rates in Mercosur countries.

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Paper provided by Department of Economics, University of Hohenheim, Germany in its series Diskussionspapiere aus dem Institut für Volkswirtschaftslehre der Universität Hohenheim with number 232/2004.

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Date of creation: 2004
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Handle: RePEc:hoh:hohdip:232

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  1. Flood, Robert P & Jeanne, Olivier, 2000. "An Interest Rate Defence of a Fixed Exchange Rate?," CEPR Discussion Papers 2507, C.E.P.R. Discussion Papers.
  2. Belke, Ansgar & Gros, Daniel, 2002. "Monetary integration in the Southern Cone," The North American Journal of Economics and Finance, Elsevier, vol. 13(3), pages 323-349, December.
  3. Flood, R.P. & Rose, A.K., 1992. "Fixing Exchange Rates: A Virtual Quest for Fundamentals," Papers 529, Stockholm - International Economic Studies.
  4. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
  5. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412 National Bureau of Economic Research, Inc.
  6. Olivier Jeanne & Andrew K. Rose, 2002. "Noise Trading And Exchange Rate Regimes," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 537-569, May.
  7. Reinhart, Carmen & Reinhart, Vincent, 2001. "What hurts most?: G-3 exchange rate or interest rate volatility," MPRA Paper 14098, University Library of Munich, Germany.
  8. Reinhart, Carmen & Calvo, Guillermo, 2001. "Fixing for your life," MPRA Paper 13873, University Library of Munich, Germany.
  9. Amartya Lahiri & Carlos A. Vegh, 2001. "Living with the Fear of Floating: An Optimal Policy Perspective," NBER Working Papers 8391, National Bureau of Economic Research, Inc.
  10. Eduardo Levy & Federico Sturzenegger, 2000. "Is EMU a Blueprint for Mercosur?," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 37(110), pages 63-99.
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Cited by:
  1. Carlos AIbarra, 2007. "Is Latin America Overcoming its Fear of Floating?," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 44(130), pages 183-209.

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