On the Relationship Between Exchange Rates and Interest Rates: Evidence from the Southern Cone

The purpose of this paper is to provide a closer view on the interaction of exchange rate volatility and interest rate volatility in the Mercosur countries. We discuss several models that explain systematic correlations between the movements of both variables and their second statistical moments, i.e. their volatilities. In contrast to the “fear of floating” argument that could lead to a volatility trade-off, we argue that both variables are largely driven either by the credibility of a country or by politics in general and thus should move in the same direction. Subsequently, we test this hypothesis of a positive correlation between both variables empirically. As a final step, we control for the impact of third variables such as exchange rate misalignment, financial stress, and monetary volatility. Our results show that – independent from third variables –there is a notable co-movement of exchange rates and interest rates in Mercosur countries.