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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.

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File URL: http://www.uni-hohenheim.de/RePEc/hoh/papers/232.pdf
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Paper provided by Department of Economics, University of Hohenheim, Germany in its series Diskussionspapiere aus dem Institut für Volkswirtschaftslehre der Universität Hohenheim with number 232/2004.

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Date of creation: 2004
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Handle: RePEc:hoh:hohdip:232
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  1. Belke, Ansgar & Gros, Daniel, 2002. "Monetary integration in the Southern Cone," The North American Journal of Economics and Finance, Elsevier, vol. 13(3), pages 323-349, December.
  2. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," Center for International and Development Economics Research, Working Paper Series qt0sx02651, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  3. Reinhart, Carmen & Reinhart, Vincent, 2001. "What hurts most?: G-3 exchange rate or interest rate volatility," MPRA Paper 14098, University Library of Munich, Germany.
  4. Flood, Robert P. & Jeanne, Olivier, 2005. "An interest rate defense of a fixed exchange rate?," Journal of International Economics, Elsevier, vol. 66(2), pages 471-484, July.
  5. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
  6. Eduardo Levy & Federico Sturzenegger, 2000. "Is EMU a Blueprint for Mercosur?," Latin American Journal of Economics-formerly Cuadernos de Economía, Instituto de Economía. Pontificia Universidad Católica de Chile., vol. 37(110), pages 63-99.
  7. Flood, Robert P. & Rose, Andrew K., 1995. "Fixing exchange rates A virtual quest for fundamentals," Journal of Monetary Economics, Elsevier, vol. 36(1), pages 3-37, August.
  8. Amartya Lahiri & Carlos A. Vegh, 2001. "Living with the Fear of Floating: An Optimal Policy Perspective," NBER Working Papers 8391, National Bureau of Economic Research, Inc.
  9. Olivier Jeanne & Andrew K Rose, 1999. "Noise trading and exchange rate regimes," Reserve Bank of New Zealand Discussion Paper Series G99/2, Reserve Bank of New Zealand.
  10. Reinhart, Carmen & Calvo, Guillermo, 2001. "Fixing for your life," MPRA Paper 13873, University Library of Munich, Germany.
  11. Carmen M. Reinhart & Vincent Raymond Reinhart, 2002. "What Hurts Emerging Markets Most? G3 Exchange Rate or Interest Rate Volatility?," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 133-170 National Bureau of Economic Research, Inc.
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