IDEAS home Printed from
MyIDEAS: Login to save this article or follow this journal

Interest rate and the exchange rate: A non-monotonic tale

  • Hnatkovska, Viktoria
  • Lahiri, Amartya
  • Vegh, Carlos A.

For over 30years, the empirical international finance literature has been unable to detect a clear systematic relationship between interest rates and the nominal exchange rate. We take a fresh look at the data and uncover a new stylized fact for a cross-section of countries: the relationship between the exchange rate and short-term interest rates is non-monotonic. Small increases in the nominal interest rate appreciate the currency, whereas larger increases depreciate the currency. We develop a model that explains this stylized fact based on the interaction of three effects. Higher interest rates increase money demand and hence appreciate the currency but also raise the fiscal deficit and depress output, both of which tend to depreciate the currency. We provide cross-country evidence for the presence of these effects in the data.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: Full text for ScienceDirect subscribers only

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 63 (2013)
Issue (Month): C ()
Pages: 68-93

in new window

Handle: RePEc:eee:eecrev:v:63:y:2013:i:c:p:68-93
Contact details of provider: Web page:

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.:

as in new window
  1. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  2. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear of Floating," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 379-408.
  3. Sergio Rebelo & Carlos A. Vegh, 1995. "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," NBER Chapters, in: NBER Macroeconomics Annual 1995, Volume 10, pages 125-188 National Bureau of Economic Research, Inc.
  4. Edwards, Sebastian & Vegh, Carlos A., 1997. "Banks and macroeconomic disturbances under predetermined exchange rates," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 239-278, October.
  5. repec:oup:qjecon:v:119:y:2004:i:1:p:1-48 is not listed on IDEAS
  6. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  7. 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.
  8. Correia, Isabel & Neves, Joao C & Rebelo, Sérgio, 1994. "Business Cycles in a Small Open Economy," CEPR Discussion Papers 996, C.E.P.R. Discussion Papers.
  9. Diaz-Gimenez, Javier & Prescott, Edward C. & Fitzgerald, Terry & Alvarez, Fernando, 1992. "Banking in computable general equilibrium economies," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 533-559.
  10. Easterly, William & Mauro, Paolo & Schmidt-Hebbel, Klaus, 1992. "Money demand and seignorage - maximizing inflation," Policy Research Working Paper Series 1049, The World Bank.
  11. Pablo Druck & Pietro Garibaldi, 2000. "Inflation Risk and Portfolio Allocation in the Banking System," CEMA Working Papers: Serie Documentos de Trabajo. 181, Universidad del CEMA.
  12. Brock, Philip L, 1989. "Reserve Requirements and the Inflation Tax," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 21(1), pages 106-21, February.
  13. Kraay, Aart, 2003. "Do high interest rates defend currencies during speculative attacks?," Journal of International Economics, Elsevier, vol. 59(2), pages 297-321, March.
  14. Bernanke, Ben S & Blinder, Alan S, 1988. "Credit, Money, and Aggregate Demand," American Economic Review, American Economic Association, vol. 78(2), pages 435-39, May.
  15. repec:oup:qjecon:v:110:y:1995:i:4:p:975-1009 is not listed on IDEAS
  16. Greenwood, Jeremy & Hercowitz, Zvi & Huffman, Gregory W, 1988. "Investment, Capacity Utilization, and the Real Business Cycle," American Economic Review, American Economic Association, vol. 78(3), pages 402-17, June.
  17. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers 4482, C.E.P.R. Discussion Papers.
  18. Allan Drazen & Stefan Hubrich, 2006. "A Simple Test of the Effect of Interest Rate Defense," NBER Working Papers 12616, National Bureau of Economic Research, Inc.
  19. Reinhart, Carmen & Rogoff, Kenneth, 2004. "The modern history of exchange rate arrangements: A reinterpretation," MPRA Paper 14070, University Library of Munich, Germany.
  20. Martin Uribe & Vivian Z. Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  21. Rabanal, Pau, 2007. "Does inflation increase after a monetary policy tightening? Answers based on an estimated DSGE model," Journal of Economic Dynamics and Control, Elsevier, vol. 31(3), pages 906-937, March.
  22. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," CEPR Discussion Papers 2963, C.E.P.R. Discussion Papers.
  23. Sims, Christopher A, 1994. "A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy," Economic Theory, Springer, vol. 4(3), pages 381-99.
  24. Meese, Richard, 1990. "Currency Fluctuations in the Post-Bretton Woods Era," Journal of Economic Perspectives, American Economic Association, vol. 4(1), pages 117-34, Winter.
  25. Carlos Montoro & Ramon Moreno, 2011. "The use of reserve requirements as a policy instrument in Latin America," BIS Quarterly Review, Bank for International Settlements, March.
  26. repec:oup:qjecon:v:117:y:2002:i:2:p:379-408 is not listed on IDEAS
  27. Calvo, Guillermo A & Vegh, Carlos A, 1995. "Fighting Inflation with High Interest Rates: The Small Open Economy Case under Flexible Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(1), pages 49-66, February.
  28. Molodtsova, Tanya & Papell, David H., 2009. "Out-of-sample exchange rate predictability with Taylor rule fundamentals," Journal of International Economics, Elsevier, vol. 77(2), pages 167-180, April.
  29. repec:tpr:qjecon:v:119:y:2004:i:1:p:1-48 is not listed on IDEAS
  30. Drazen, Allan & Hubrich, Stefan, 2006. "A simple test of the effect of interest rate defense," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 612-636, December.
  31. Carlos Vegh & Amartya Lahiri & Viktoria Hnatkovska, 2011. "The Exchange Rate Response Puzzle," 2011 Meeting Papers 425, Society for Economic Dynamics.
  32. repec:tpr:qjecon:v:117:y:2002:i:2:p:379-408 is not listed on IDEAS
  33. Kiguel, Miguel A, 1989. "Budget Deficits, Stability, and the Monetary Dynamics of Hyperinflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 21(2), pages 148-57, May.
  34. Thorsten Beck & Asli Demirgüç-Kunt & Ross Levine, 2000. "A New Database on the Structure and Development of the Financial Sector," World Bank Economic Review, World Bank Group, vol. 14(3), pages 597-605, September.
  35. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
Full references (including those not matched with items on IDEAS)

This item is featured on the following reading lists or Wikipedia pages:

  1. Canadian Macro Study Group

When requesting a correction, please mention this item's handle: RePEc:eee:eecrev:v:63:y:2013:i:c:p:68-93. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Zhang, Lei)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.