NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

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

Viktoria Hnatkovska, Amartya Lahiri, Carlos A. Vegh

NBER Working Paper No. 13925
Issued in April 2008
NBER Program(s):   IFM

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.

download in pdf format
   (589 K)

email paper

This paper is available as PDF (589 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w13925

Published: European Economic Review Volume 63, October 2013, Pages 68–93 citation courtesy of

Users who downloaded this paper also downloaded these:
Ito, Isard, and Symansky Economic Growth and Real Exchange Rate: An Overview of the Balassa-Samuelson Hypothesis in Asia
Mussa The Theory of Exchange Rate Determination
Engel w17116 The Real Exchange Rate, Real Interest Rates, and the Risk Premium
Cho and West Interest Rates and Exchange Rates in the Korean, Philippine, and Thai Exchange Rate Crises
Edwards w12163 The Relationship Between Exchange Rates and Inflation Targeting Revisited
 
Publications
Activities
Meetings
NBER Videos
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us