Working Paper: CEPR ID: DP6501
Authors: Carlos Eduardo Soares Gonalves; Bernardo Guimares
Abstract: In a country with high probability of default, higher interest rates may render the currency less attractive if sovereign default is costly. This paper develops that intuition in a simple model and estimates the effect of changes in interest rates on the exchange rate in Brazil using data from the dates surrounding the monetary policy committee meetings and the methodology of identification through heteroskedasticity. Indeed, we find that unexpected increases in interest rates tend to lead the Brazilian currency to depreciate. It follows that granting more independence to a central bank that focus solely on inflation is not always a free-lunch.
Keywords: Default; Exchange Rate; Identification through Heteroskedasticity; Monetary Policy
JEL Codes: E5; F3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher interest rates (E43) | currency depreciation (F31) |
| unexpected increases in interest rates (E43) | currency depreciation (F31) |
| higher interest rates (E43) | strengthen currency (F31) |
| higher interest rates beyond a certain threshold (E43) | currency depreciation (F31) |
| heightened default risk (G33) | currency depreciation (F31) |