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Revisiting the Interest Rate-Exchange Rate Nexus: A Markov Switching Approach

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  • Shiu-Sheng Chen

    (University of Wisconsin-Madison)

Abstract

In this paper the interest rate-exchange rate nexus and the effectiveness of interest rate defence are investigated theoretically and empirically. We construct a simple theoretical model by incorporating Taylor rule in the model proposed by Jeanne and Rose (2002). Mixing the macroeconomic theory of exchange rate determination and the noise trading approach to asset price volatility, we present a model with multiple equilibria, which thereafter implies a possible switching between the regimes of high and low volatility of the exchange rates. The theoretical model motivates us to adopt a Markov-switching specification of the nominal exchange rate with time-varying transition probabilities. By investigating the data of Indonesia, South Korea, the Philippines, Thailand, Mexico, Hong Kong, and Turkey, it is shown that raising nominal interest rates leads to a higher probability of switching to a crisis regime. Thus, the empirical results presented here support the views that high interest rate policy is unable to defend the exchange rate. Unlike other studies which consider linear models only, our findings are robust and consistent over different countries and crisis episodes (Asian 1997 crises, Mexico 1994 crisis, and Turkey 1994, 2001 crises). In addition, this paper provides some evidences supporting the view of ``fear of floating''.

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Bibliographic Info

Paper provided by EconWPA in its series International Finance with number 0303002.

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Length: 50 pages
Date of creation: 06 Mar 2003
Date of revision: 13 Mar 2003
Handle: RePEc:wpa:wuwpif:0303002

Note: Type of Document - ; pages: 50 ; figures: included. Preliminary. Comments welcome.
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Web page: http://128.118.178.162

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Keywords: Exchange rates; Interest rates; Markov switching model;

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References

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Citations

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Cited by:
  1. James Tybout & Hale Utar & Eric Bond, 2009. "Credit Rationing, Risk Aversion and Industrial Evolution in Developing Countries," 2009 Meeting Papers 351, Society for Economic Dynamics.
  2. Hsing, Yu, 2009. "Analysis of the Behavior of the New Zealand Dollar Exchange Rate: Comparison of Four Major Models," Review of Applied Economics, Review of Applied Economics, vol. 5(1-2).
  3. Chen, Shiu-Sheng, 2007. "A note on interest rate defense policy and exchange rate volatility," Economic Modelling, Elsevier, vol. 24(5), pages 768-777, September.
  4. Lee, Hsiu-Yun, 2011. "Nonlinear exchange rate dynamics under stochastic official intervention," Economic Modelling, Elsevier, vol. 28(4), pages 1510-1518, July.
  5. Shiu-Sheng Chen, 2003. "Revisiting the Interest Rate-Exchange Rate Nexus: A Markov Switching Approach," International Finance 0303002, EconWPA, revised 13 Mar 2003.
  6. Tsen, Wong Hock, 2011. "The real exchange rate determination: An empirical investigation," International Review of Economics & Finance, Elsevier, vol. 20(4), pages 800-811, October.
  7. Francis Y. Kumah, 2007. "A Markov-Switching Approach to Measuring Exchange Market Pressure," IMF Working Papers 07/242, International Monetary Fund.
  8. Ahmad Zubaidi Baharumshah & Venus Khim-Sen Liew & Ron Mittelhammer, 2010. "Non-linearities in Real Interest Rate Parity: Evidence from OECD and Asian Developing Economies," Global Economic Review, Taylor & Francis Journals, vol. 39(4), pages 351-364.
  9. Christoph Himmels & Tatiana Kirsanova, 2009. " The Interest Rate — Exchange Rate Nexus: Exchange Rate Regimes and Policy Equilibria," CDMA Conference Paper Series 0902, Centre for Dynamic Macroeconomic Analysis.

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