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

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

Abstract

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.

Suggested Citation

  • Hnatkovska, Viktoria & Lahiri, Amartya & Vegh, Carlos A., 2013. "Interest rate and the exchange rate: A non-monotonic tale," European Economic Review, Elsevier, vol. 63(C), pages 68-93.
  • Handle: RePEc:eee:eecrev:v:63:y:2013:i:c:p:68-93 DOI: 10.1016/j.euroecorev.2013.06.001
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    Cited by:

    1. Marcelo Moura, 2010. "Testing the Taylor Model Predictability for Exchange Rates in Latin America," Open Economies Review, Springer, vol. 21(4), pages 547-564, September.
    2. Tito Cordella & Pablo M. Federico & Carlos A. Vegh & Guillermo Vuletin, 2014. "Reserve Requirements in the Brave New Macroprudential World," World Bank Publications, The World Bank, number 17584.
    3. Bratsiotis, George J. & Robinson, Wayne A., 2016. "Unit Total Costs: An Alternative Marginal Cost Proxy for Inflation Dynamics," EconStor Open Access Articles, ZBW - German National Library of Economics, pages 1826-1849.
    4. Carlos A. Vegh & Guillermo Vuletin, 2013. "Overcoming the Fear of Free Falling: Monetary Policy Graduation in Emerging Markets," World Scientific Book Chapters,in: The Role of Central Banks in Financial Stability How Has It Changed?, chapter 6, pages 105-129 World Scientific Publishing Co. Pte. Ltd..
    5. Brahima Coulibaly, 2012. "Monetary policy in emerging market economies: what lessons from the global financial crisis?," International Finance Discussion Papers 1042, Board of Governors of the Federal Reserve System (U.S.).
    6. Nicholas Apergis & Arusha Cooray, 2013. "Forecasting fiscal variables: Only a strong growth plan can sustain the Greek austerity programs - Evidence from simultaneous and structural models," CAMA Working Papers 2013-25, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    7. Lindenberg, Nannette & Westermann, Frank, 2012. "Common trends and common cycles among interest rates of the G7-countries," Journal of Macroeconomics, Elsevier, pages 1125-1140.
    8. Selim KAYHAN & Tayfur BAYAT & Ahmet UGUR, 2013. "Interest Rates and Exchange Rate Relationship in BRIC-T Countries," Ege Academic Review, Ege University Faculty of Economics and Administrative Sciences, vol. 13(2), pages 227-236.
    9. Javier Gómez Pineda, 2004. "Inflation Targeting, Sudden Stops and the Cost of Fear of Floating," Borradores de Economia 276, Banco de la Republica de Colombia.

    More about this item

    Keywords

    Interest rate policy; Flexible exchange rates; Currency;

    JEL classification:

    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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