Exchange Rate Dynamics Under a Currency Board When Policy Rates are Zero
HKIMR Working Paper No. 21/2017
20 Pages Posted: 20 Sep 2017
Date Written: September 18, 2017
In a target-zone exchange rate system, both fundamentals and exchange rate expectations, reflected in interest rate differentials between the domestic and anchor currency, determine the exchange rate. However, the scope to capture exchange rate expectations is limited when policy rates are close to their zero lower bound, especially in a narrow-band target zone or currency board. Cook and Yetman (2014) introduce a new mechanism, based on a central bank’s balance sheet, which works to bring about equilibrium in currency markets even when interest rates are zero. To investigate how interest rate differentials and balance sheets (monetary base) affect exchange rate dynamics, this paper uses a target-zone model with asymmetric mean-reverting fundamental dynamics to test the data for the Hong Kong dollar (HKD) pegged with the US dollar (USD) under a zero-interest rate environment. The empirical results suggest that the restoring force and long-term mean of the exchange rate dynamics are cointegrated with the monetary base, as well as HKD-USD interest rate differentials. Appreciation (depreciation) expectations of the HKD reflected in the dynamics are positively (negatively) related to capital inflows (interest rate differentials).
Keywords: Target zone model, currency board, Hong Kong dollar
JEL Classification: F31, G13
Suggested Citation: Suggested Citation