The Relationship between Exchange Rates and Interest Rates in a Small Open Emerging Economy: The Case of Romania

44 Pages Posted: 14 Mar 2016 Last revised: 2 Feb 2017

See all articles by Alin Marius Andries

Alin Marius Andries

Alexandru Ioan Cuza University of Iasi; Romanian Academy - Institute for Economic Forecasting

Iulian Ihnatov

Alexandru Ioan Cuza University

Bogdan CĂPRARU

Faculty of Economics and Business Administration, Alexandru Ioan Cuza University of Iași; National Institute for Economic Research, Romanian Academy

Aviral Kumar Tiwari

Indian Institute of Management Bodh Gaya

Date Written: December 15, 2016

Abstract

This paper revisits the relationship between interest rates and exchange rates in a small open emerging economy using wavelet-based methodologies. Based on data for Romania, our results confirm the theoretical predictions on the interest rate - exchange rate relationship during turmoil or policy changes. In the short term, the relationship is negative, confirming the sticky-price models, and over the long term, the relationship is positive, confirming the Purchasing Power Parity theory. At the beginning of the turmoil, the exchange rate movements generally take the lead over the interest rates for the first month, but the monetary authorities take the lead afterwards. Our results reveal that in a small open emerging economy with a direct inflation targeting monetary policy regime, the relationship between exchange rates and interest rate is fundamentally different from that in an advanced economy. Also, our results stress the necessity that the central bank must pay simultaneous attention to both variables in order to achieve their monetary policy targets.

Keywords: interest rates; exchange rates; Purchasing Power Parity theory; monetary policy; wavelet

JEL Classification: F31, E43, E58

Suggested Citation

Andries, Alin Marius and Ihnatov, Iulian and CĂPRARU, Bogdan and Tiwari, Aviral Kumar, The Relationship between Exchange Rates and Interest Rates in a Small Open Emerging Economy: The Case of Romania (December 15, 2016). Economic Modelling, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2747064 or http://dx.doi.org/10.2139/ssrn.2747064

Alin Marius Andries (Contact Author)

Alexandru Ioan Cuza University of Iasi ( email )

Bvd. Carol nr. 22
Iasi, 700505
Romania

HOME PAGE: http://www.feaa.uaic.ro/faculty/marius-alin-andries/

Romanian Academy - Institute for Economic Forecasting ( email )

Calea 13 Septembrie nr. 13
Bucharest, 050711
Romania

Iulian Ihnatov

Alexandru Ioan Cuza University ( email )

Carol I Blvd, Nr.11
Lasi
Romania

Bogdan CĂPRARU

Faculty of Economics and Business Administration, Alexandru Ioan Cuza University of Iași ( email )

Carol I Blvd, Nr.22
Iasi, 700505
Romania

HOME PAGE: http://www.uaic.ro

National Institute for Economic Research, Romanian Academy ( email )

Calea 13 Septembrie 13
Bucharest
Romania

HOME PAGE: http://ince.ro/index.html

Aviral Kumar Tiwari

Indian Institute of Management Bodh Gaya ( email )

Uruvela, Prabandh Vihar, Bodh Gaya
Bodh Gaya, 824234
India

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