How Does Information Affect the Comovement between Interest Rates and Exchange Rates?

51 Pages Posted: 1 May 2006

Date Written: April 2006

Abstract

This paper compares the link between exchange rates and interest rates under full information and two alternative asymmetric information approaches. It also distinguishes between cases of expansionary and contractionary depreciations. Full information results are not robust to the presence of informational frictions. For economies exhibiting expansionary or strongly contractionary depreciations, such frictions lead to two optimal deviations from full information outcomes: i) under asymmetric information with signal extraction, the realisation of a relatively less frequent shock leads the central bank to behave as if a more likely disturbance had instead taken place; and ii) under asymmetric information without signal extraction, the monetary authority does not react on impact to shocks. Finally, in the case of mildly contractionary depreciations, both asymmetric information models predict a lack of response of the central bank to aggregate demand shocks, as opposed to an offsetting movement in interest rates under full information.

Keywords: Transmission mechanism, Emerging market economies, Exchange rate, Monetary policy, Imperfect information

JEL Classification: E52, E58, F31, F41

Suggested Citation

Sanchez, Marcelo, How Does Information Affect the Comovement between Interest Rates and Exchange Rates? (April 2006). ECB Working Paper No. 608, Available at SSRN: https://ssrn.com/abstract=890993

Marcelo Sanchez (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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