2008),“Interest Rates and the Exchange Rate: A NonMonotonic Tale

1We would like to thank seminar participants at the Federal Reserve Bank of New York, HEC Montreal, Colorado-Boulder, UBC, the 2007 annual meetings of Midwest Macro, CMSG Jr., and the SED for helpful comments. Lahiri would also like to thank SSHRC for research support. 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 show that the model can replicate the heterogeneous responses of the exchange rate to interest rate innovations in several developing economies. JEL Classification: F3, F