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The Exchange Rate Response Puzzle

Listed author(s):
  • Carlos Vegh

    (University of Maryland)

  • Amartya Lahiri

    (UBC)

  • Viktoria Hnatkovska

    (UBC)

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.

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File URL: https://economicdynamics.org/meetpapers/2011/paper_425.pdf
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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 425.

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Date of creation: 2011
Handle: RePEc:red:sed011:425
Contact details of provider: Postal:
Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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  1. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," NBER Technical Working Papers 0282, National Bureau of Economic Research, Inc.
  2. Fernando Alvarez & Terry J. Fitzgerald, 1992. "Banking in computable general equilibrium economies: technical appendices I and II," Staff Report 155, Federal Reserve Bank of Minneapolis.
  3. Neumeyer, Pablo A. & Perri, Fabrizio, 2005. "Business cycles in emerging economies: the role of interest rates," Journal of Monetary Economics, Elsevier, vol. 52(2), pages 345-380, March.
  4. Martin Uribe & Vivian Z. Yue, 2003. "Country Spreads and Emerging Countries: Who Drives Whom?," NBER Working Papers 10018, National Bureau of Economic Research, Inc.
  5. Maurice Obstfeld & Kenneth Rogoff & Ben Bernanke & Kenneth Rogoff, "undated". "The Six Major Puzzles in International Macroeconomics: Is there a Common Cause?," Working Paper 32326, Harvard University OpenScholar.
  6. Edwards, Sebastian & Vegh, Carlos A., 1997. "Banks and macroeconomic disturbances under predetermined exchange rates," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 239-278, October.
  7. Meese, Richard, 1990. "Currency Fluctuations in the Post-Bretton Woods Era," Journal of Economic Perspectives, American Economic Association, vol. 4(1), pages 117-134, Winter.
  8. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711.
  9. Kraay, Aart, 2003. "Do high interest rates defend currencies during speculative attacks?," Journal of International Economics, Elsevier, vol. 59(2), pages 297-321, March.
  10. Pablo Druck & Pietro Garibaldi, 2000. "Inflation Risk and Portfolio Allocation in the Banking System," CEMA Working Papers: Serie Documentos de Trabajo. 181, Universidad del CEMA.
  11. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
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