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The Exchange Rate Response Puzzle

Author

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  • Carlos Vegh

    (University of Maryland)

  • Amartya Lahiri

    (UBC)

  • Viktoria Hnatkovska

    (UBC)

Abstract

Standard models in open economy macroeconomics predict that an expansionary (contractionary) monetary policy will lead to a currency depreciation (appreciation). Models that generate this prediction include the Dornbusch overshooting model, the flexible price model, the liquidity-effect models, as well as models based on the fiscal theory. The data however reveals an interesting twist to this prediction. We study a sample of 25 industrial and 49 developing countries and find that while the nominal exchange rate does indeed tend to appreciate in response to interest rate increases in developed countries, in develping countries the effect tends to be the opposite. In particular, in 84 percent of the developing countries in our sample, the nominal exchange rate depreciates in response to an increase in the interest rate. These findings represent a puzzle for standard models. To rationalize these empirical facts, we develop a model with two liquid assets (cash and demand-deposits) in which the central bank controls the interest rate on the liquid asset. The government finances its budget deficit with inflationary finance and firms must rely on bank credit to finance their working capital. The model generates opposing effects of interest rate changes on the exchange rate -- a money demand effect, a fiscal effect and an output effect. We show that a calibrated version of the model rationalizes the opposing responses in developed and developing countries.

Suggested Citation

  • Carlos Vegh & Amartya Lahiri & Viktoria Hnatkovska, 2011. "The Exchange Rate Response Puzzle," 2011 Meeting Papers 425, Society for Economic Dynamics.
  • Handle: RePEc:red:sed011:425
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    File URL: https://economicdynamics.org/meetpapers/2011/paper_425.pdf
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    References listed on IDEAS

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