TY  - JOUR
AU  - Hnatkovska,Viktoria
AU  - Lahiri,Amartya
AU  - Vegh,Carlos A.
TI  - Interest Rates and the Exchange Rate: A Non-Monotonic Tale
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 13925
PY  - 2008
Y2  - April 2008
UR  - http://www.nber.org/papers/w13925
L1  - http://www.nber.org/papers/w13925.pdf
N1  - Author contact info:
Viktoria Hnatkovska
Department of Economics
University of British Columbia
Vancouver, BC V6T 1Z1
E-Mail: hnatkovs@interchange.ubc.ca

Amartya Lahiri
Department of Economics
University of British Columbia
Vancouver, BC V6T 1Z1
Tel: 604-822-8606
E-Mail: alahiri@interchange.ubc.ca

Carlos A. Vegh
Department of Economics
Tydings Hall, Office 4118G
University of Maryland
College Park, MD 20742-7211
Tel: 301-405-3546
Fax: 301-405-3542
E-Mail: vegh@econ.bsos.umd.edu
AB  - 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.
ER  -