Working Paper: NBER ID: w13925
Authors: Viktoria Hnatkovska; Amartya Lahiri; Carlos A. Vegh
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; nonmonotonic relationship
JEL Codes: E52; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher domestic interest rates (E43) | Increase in the demand for deposits (E41) |
| Increase in the demand for deposits (E41) | Appreciate the currency (F31) |
| Higher domestic interest rates (E43) | Fiscal burden on the government increases (E62) |
| Higher domestic interest rates (E43) | Output decreases (E23) |
| Fiscal burden on the government increases and Output decreases (E62) | Depreciate the currency (F31) |
| Higher domestic interest rates (E43) | Nonmonotonic relationship with exchange rates (F31) |