Revisiting the interest rate-exchange rate nexus: A Markov-switching approach
Journal
Journal of Development Economics
Journal Volume
79
Journal Issue
1
Pages
208-224
Date Issued
2006
Author(s)
Abstract
In this paper the interest rate-exchange rate nexus and the effectiveness of an interest rate defense are investigated empirically. I present a reduced form evidence which characterizes the empirical relationship between interest rates and exchange rates. I use a Markov-switching specification of the nominal exchange rate with time-varying transition probabilities. Empirical evidence from six developing countries: Indonesia, South Korea, the Philippines, Thailand, Mexico, and Turkey indicates that raising nominal interest rates leads to a higher probability of switching to a crisis regime. Thus, the empirical results presented here may support the view that a high interest rate policy is unable to defend the exchange rate. Unlike other studies which consider linear models only, my findings are robust and consistent over different countries and crisis episodes (Asian 1997 crises, Mexico 1994 crisis, and Turkey 1994, 2001 crises). In order to explain the empirical findings, I construct a simple theoretical model by incorporating an interest rate rule in the model proposed by Jeanne and Rose (2002) [Jeanne, O., Rose, A.K., 2002. Noise trading and exchange rate regimes, Quarterly Journal of Economics. 117 (2) 537-569]. The model has multiple equilibria, and under plausible conditions, higher exchange rate volatility is associated with higher interest rates. © 2005 Elsevier B.V. All rights reserved.
SDGs
Type
journal article