The Exchange Rate and Interest Rate Differential Relationship: Evidence from Two Financial Crises

Li, Kui-Wai and Wong, Douglas K T (2011): The Exchange Rate and Interest Rate Differential Relationship: Evidence from Two Financial Crises.

Abstract

This paper examines the contemporaneous and inter-temporal interaction between real exchange rate and real interest rate differential in the two financial crises of 1997 and 2008 by using data from thirteen countries from different world regions. The empirical result shows that negative contemporaneous relationship exists in most countries. In addition, there is little evidence on a systematic inter-temporal relationship between the real interest rate differential and the real exchange rate, and an absence of consistent result in supporting a negative relationship among the thirteen economies. An extremely low change in the conditional correlation between real interest rate differential and real exchange rates can be found in small countries.

• Item Type: MPRA Paper
• Language: English
• Keywords: Contemporaneous, inter-temporal relationship, exchange rate, interest rate differential, financial crisis
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E43 - Interest Rates: Determination, Term Structure, and Effects; O - Economic Development, Innovation, Technological Change, and Growth > O5 - Economywide Country Studies > O57 - Comparative Studies of Countries; C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C22 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes; F - International Economics > F3 - International Finance > F31 - Foreign Exchange

References

Bautista, C. C., (2006), “The exchange rate-interest differential relationship in six East Asian countries”, Economics Letters, 92, 137-142.

Bilson, J., (1978), “The monetary approach to exchange rate – some empirical evidence,” IMF Staff Papers, 25, 48-75.

Blundell-Wignall, A. and F. Browne, (1991), Increase Financial Market Integration, Real Exchange Rates and Macroeconomic Adjustment, OECD Working Paper 96, February.

Boughton, J.M., (1987), “Tests of the performance of reduced-form exchange rate models”, Journal of International Economics, 23, 41–56.

Calvo, G., (1998), “Capital flows and capital-market crises: the simple economics of sudden stops”, Applied Economics, 1 November, 35-54.

Chari, V. V. and Kehoe, P. J., (2003), “Hot money”, Journal of Political Economy, 111 (6), 1262-1292.

Corsetti, G., Prsenti, P. and Roubini, N., (1999), “What caused the Asian currency and financial crisis?”, Japan and the World Economy, 11, 305-373.

Coughlin C. C., and Koedijk, K., (1990), “What do we know about the long-run real exchange rate?”, St. Louis Federal Reserve Bank Review, 72, 36-48.

Dornbusch, R., (1976), “Expectations and exchange rate dynamics,” Journal of Political Economy, 84, 1161–1176.

Edison, H. J. and Melick, W. R., (1999), “Alternative approaches to real exchange rates and real interest rate: Three up and three down”, International Journal of Finance and Economics, 4, 93-111.

Edison, H. J. and Pauls, B., (1993), “A re-assessment of the relationship between real exchange rate and real interest rates: 1974-1990”, Journal of Monetary Economics, 31 (2), 165-187.

Eichengreen, B., Ito, T., Kawai, M. and Portes, R., (1998), “Recent currency crisis in Asia”, Journal of the Japanese and International Economies, 12, 535-542.

Engle, R. F. and Sheppard, K., (2001), Theoretical and Empirical Properties of Dynamic Conditional Correlation Multivariate GARCH, National Bureau of Economic Research, Working Paper, No. 8554, Cambridge, MA.

Engle, R. F., (2002), “Dynamic conditional correlation - a simple class of multivariate GARCH models”, Journal of Business and Economics Statistics, 20, 339-350.

Frankel, J., (1976), “A monetary approach to exchange rate: Doctrinal aspects and empirical evidence”, Scandinavian Journal of Economics, 78, 255-276.

Frankel, J., (1979), “On the mark: A theory of floating exchange rates based on real interest differential”, American Economic Review, 69, 610–622.

Financial Services Authority, (2009), The Turner Review: A Regulatory Response to the Global Banking Crisis, London, March.

Fleming, J. M., (1962), “Domestic financial policies under fixed and under floating exchange rates”, IMF Staff Papers, 9, 369–379.

Gokhale, Jagadeesh and Van Doren, Peter, (2009), Would Stricter Fed Policy and Financial Regulation Have Averted the Financial Crisis?, Cato Institute Policy Analysis, No. 648, October.

Hoffmann, M. and MacDonald, R., (2009), “Real exchange rates and real interest rate differentials: A present value interpretation”, European Economic Review, vol. 53(8), 952-970.

Hooper P. and Morton J., (1982), “Fluctuations in the dollar: A model of nominal and real exchange rate determination”. Journal of International Money and Finance 1, 39–56.

Hosking, J. (1980), “The multivariate portmanteau statistic”, Journal of American Statistical Association, 75, 602-608.

International Monetary Fund, (2009), Global Financial Stability Report: Responding to the Financial Crisis and Measuring Systemic Risks, Washington D. C., April.

Kaminsky, G., Lozondo, S. and Reinhart, C., (1998), “Leading indicators of currency crisis”, IMF Staff Papers, 45 (1) March: 1-48.

Krugman, P., (1998a), What Happened to Asia?, Massachusetts Institute of Technology, Cambridge: MA.

Krugman, P., (1998b), Fire Sale FDI, Massachusetts Institute of Technology, Cambridge: MA.

MacDonald R., (1998), “What determines real exchange rate: the long and short for it”, Journal of International Financial Markets, Institutions, and Money, 8, 117 -153.

Meese, R., Rogoff, K. (1988), “Was it real? The exchange rate-interest rate differential relation over the modern floating-rate period”, Journal of Finance, 43, (4), 933-948.

Meltzer, Allan H. (2009), “Reflections on the financial crisis”, Cato Journal, 29 (1), 25-30.

Mundell, R. A., (1961), “A theory of optimum currency areas”, American Economic Review, 51, 657–665.

Obstfeld, M. and Rogoff, K. (1984), “Sticky-price exchange rate models under alternative price-adjustment rules”, International Economic Review, 25, 159-174.

Pan, M. S., Fok, R. C. W. and Liu, Y. A. (2001), Dynamic Linkages between Exchange Rates and Stock Prices: Evidence from Pacific Rim Countries, Working Paper, College of Business, Shippensburg University.

Radelet, S. and Sachs, J., (1998a), The East Asian Financial Crisis: Diagnosis, Remedies and Prospects, Harvard Institute for International Development, Cambridge: MA.

Radelet, S. and Sachs, J., (1998b), The Onset of the East Asian Financial Crisis, Harvard Institute for International Development, Cambridge: MA.

Rigobon, R., (1998), Information Speculative Attacks: Good News is No News, Massachusetts Institute of Technology, Cambridge: MA.

Schwartz, Anna J., (2009), “Origins of the financial market crisis of 2008”, Cato Journal, 29 (1), 19-23.

Sollis, R. and Wohar, M. E., (2006), “The real exchange rate – real interest rate relation: Evidence from tests for symmetric and asymmetric threshold cointegration”, International Journal of Finance and Economics, 11, 139-153.