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

Author

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  • Hacker, Scott

    (Jonkoping International Business School)

  • Kim, Hyunjoo

    (Jonkoping International Business School)

  • Månsson, Kristofer

    (Jonkoping International Business School)

Abstract

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.

Suggested Citation

  • Hacker, Scott & Kim, Hyunjoo & Månsson, Kristofer, 2010. "The Relationship between Exchange Rates and Interest Rate Differentials: a Wavelet Approach," Working Paper Series in Economics and Institutions of Innovation 217, Royal Institute of Technology, CESIS - Centre of Excellence for Science and Innovation Studies.
    • Handle: RePEc:hhs:cesisp:0217
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    References listed on IDEAS

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    More about this item

    Keywords

    exchange rates; interest rate differential; uncovered interest parity; monetary approach; small-economy; wavelet analysis;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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