The Non--Monotonic Relationship between Interest Rates and Exchange Rates
We calibrate the model to match the business cycle regularities of emerging economies. We then conduct policy experiments involving the domestic interest rate and demonstrate the central result of the paper: the relationship between interest rates and exchange rates is non-monotonic. We find that increases in the interest rate up to 35% both appreciate the currency and induce a fall in the rate of currency depreciation. However, more aggressive increases in the domestic interest rate both depreciate the currency as well as increase the rate of currency depreciation. Our results provide an explanation for the inability of non-structural empirical models to find a systematic relationship.
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