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Interest rate and the exchange rate: A non-monotonic tale

Viktoria Hnatkovska (), Amartya Lahiri and Carlos Vegh ()

European Economic Review, 2013, vol. 63, issue C, 68-93

Abstract: For over 30years, the empirical international finance literature has been unable to detect a clear systematic relationship between interest rates and the nominal exchange rate. We take a fresh look at the data and uncover a new stylized fact for a cross-section of countries: the relationship between the exchange rate and short-term interest rates is non-monotonic. Small increases in the nominal interest rate appreciate the currency, whereas larger increases depreciate the currency. We develop a model that explains this stylized fact based on the interaction of three effects. Higher interest rates increase money demand and hence appreciate the currency but also raise the fiscal deficit and depress output, both of which tend to depreciate the currency. We provide cross-country evidence for the presence of these effects in the data.

Keywords: Interest rate policy; Flexible exchange rates; Currency (search for similar items in EconPapers)
JEL-codes: F3 F4 (search for similar items in EconPapers)
Date: 2013
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Working Paper: Interest Rates and the Exchange Rate: A Non-Monotonic Tale (2008) Downloads
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