The Link between Interest Rates and Exchange Rates: Do Contractionary Depreciations Make a Difference?

55 Pages Posted: 11 Nov 2005

Date Written: November 2005

Abstract

The link between exchange rates and interest rates features prominently in the theoretical and empirical literature on small open economies. This paper revisits this relationship using a simple model that incorporates the role of exchange rate pass-through into domestic prices and distinguishes between cases of expansionary and contractionary depreciations. The model results show that the correlation between exchange rates and interest rates, conditional on an adverse risk premium shock, is negative for expansionary depreciations and positive for contractionary ones. For this type of shock, interest rates are found to be raised to prevent the contractionary effect of a depreciation regardless of whether the latter effect is strong or mild. Interest rates are predicted to also rise in response to an adverse net export shock in contractionary depreciation cases, and to be lowered in the case of expansionary ones.

Keywords: Transmission mechanism, emerging market economies, Exchange rate, Monetary policy

JEL Classification: E52, E58, F31, F41

Suggested Citation

Sanchez, Marcelo, The Link between Interest Rates and Exchange Rates: Do Contractionary Depreciations Make a Difference? (November 2005). ECB Working Paper No. 548, Available at SSRN: https://ssrn.com/abstract=839229

Marcelo Sanchez (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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