The link between interest rates and exchange rates: do contractionary depreciations make a difference?

Abstract

This paper revisits the relationship between interest rates and exchange rates 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 eventually rise in response to an adverse net export shock in contractionary depreciation cases, and to be lowered in the case of expansionary ones.

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