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How Does Information Affect the Comovement Between Interest Rates and Exchange Rates?

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  • Marcelo SANCHEZ

    () (European Central Bank)

Abstract

This paper sets up a small open economy model to compare the link between exchange rates and interest rates under full and imperfect information. The informational friction considered here corresponds to the case where the central bank, while failing to observe output and inflation, can extract some information about these variables from the private sector (asymmetric information with signal extraction). This informational friction generates an optimal deviation from the full information outcome, with the realisation of a relatively less frequent shock leading the central bank to behave as if a more likely disturbance had instead taken place. This indicates that policies that would be optimal under full information are not optimal when knowledge is imperfect.

Suggested Citation

  • Marcelo SANCHEZ, 2007. "How Does Information Affect the Comovement Between Interest Rates and Exchange Rates?," Rivista Internazionale di Scienze Sociali, Vita e Pensiero, Pubblicazioni dell'Universita' Cattolica del Sacro Cuore, vol. 115(4), pages 547-562.
  • Handle: RePEc:vep:journl:y:2007:v:115:i:4:p:547-562
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    More about this item

    Keywords

    Transmission mechanism; Exchange rate; Optimal monetary policy; Imperfect information;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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