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

43 Pages Posted: 21 Mar 2008 Last revised: 22 Apr 2008

See all articles by Viktoria V. Hnatkovska

Viktoria V. Hnatkovska

University of British Columbia (UBC) - Department of Economics

Amartya Lahiri

University of British Columbia (UBC) - Department of Economics

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS); University of Maryland - Department of Economics; University of California at Los Angeles; National Bureau of Economic Research (NBER)

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Date Written: March 8, 2008

Abstract

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.

Keywords: Interest rates, exchange rates, currency depreciation, interest rate policy

JEL Classification: F3, F4

Suggested Citation

Hnatkovska, Viktoria V. and Lahiri, Amartya and Vegh, Carlos A., Interest Rates and the Exchange Rate: A Non-Monotonic Tale (March 8, 2008). Available at SSRN: https://ssrn.com/abstract=1111374 or http://dx.doi.org/10.2139/ssrn.1111374

Viktoria V. Hnatkovska (Contact Author)

University of British Columbia (UBC) - Department of Economics ( email )

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HOME PAGE: http://faculty.arts.ubc.ca/vhnatkovska/

Amartya Lahiri

University of British Columbia (UBC) - Department of Economics ( email )

997-1873 East Mall
Vancouver, BC V6T 1Z1
Canada
604.822.8606 (Phone)

HOME PAGE: http://www.econ.ubc.ca/alahiri/

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS) ( email )

1740 Massachusetts Avenue, NW
Washington, DC 20036-1984
United States

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States

University of California at Los Angeles ( email )

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United States
310-825-7371 (Phone)
310-825-9528 (Fax)

HOME PAGE: http://vegh.sscnet.ucla.edu

National Bureau of Economic Research (NBER)

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