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Interest Rates and the Exchange Rate: A Non-Monotonic Tale

  • Viktoria Hnatkovska
  • Amartya Lahiri
  • Carlos A. Vegh

What is the relationship between interest rates and the exchange rate? The empirical literature in this area has been inconclusive. We use an optimizing model of a small open economy to rationalize the mixed empirical findings. The model has three key margins. First, higher domestic interest rates raise the demand for deposits, and, hence, the money base. Second, firms need bank loans to finance the wage bill, which reduces output when domestic interest rates increase. Lastly, higher interest rates raise the government's fiscal burden, and, therefore, can lead to higher expected inflation. While the first effect tends to appreciate the currency, the remaining two effects tend to depreciate it. We then conduct policy experiments using a calibrated version of the model and show the central result of the paper: the relationship between interest rates and the exchange rate is non-monotonic. In particular, the exchange rate response depends on the size of the interest rate increase and on the initial level of the interest rate. Moreover, we also show that the model can replicate the heterogeneous responses of the exchange rate to interest rate innovations in several developing economies.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13925.

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Date of creation: Apr 2008
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Publication status: published as European Economic Review Volume 63, October 2013, Pages 68–93
Handle: RePEc:nbr:nberwo:13925
Note: IFM
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