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The Relationship between Exchange Rates and Interest Rate Differentials: A Wavelet Approach

  • R. Scott Hacker
  • Hyunjoo Kim Karlsson
  • Kristofer Månsson

This paper uses wavelet analysis to investigate the relationship between the spot exchange rate and the interest rate differential for seven pairs of countries, with a small country, Sweden, included in each of the cases. The key empirical results show that there tends to be a negative relationship between the spot exchange rate (domestic-currency price of foreign currency) and the nominal interest rate differential (approximately the domestic interest rate minus the foreign interest rate) at the shortest time scales, while a positive relationship is shown at the longest time scales. This indicates that among models of exchange rate determination using the asset approach, the sticky-price models are supported in the short-run while in the long-run the flexible-price models appear to better explain the sign of the relationship.

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File URL: http://hdl.handle.net/10.1111/j.1467-9701.2012.01466.x
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Article provided by Wiley Blackwell in its journal The World Economy.

Volume (Year): 35 (2012)
Issue (Month): 9 (09)
Pages: 1162-1185

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Handle: RePEc:bla:worlde:v:35:y:2012:i:9:p:1162-1185
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