On The Relationship Between Exchange Rate And Interest Rate Differential In Monetary Models

This paper reexamines some unsettled theoretical and empirical issues regarding the relationship between nominal exchange rates and interest rate differentials and provides a model for the behavior of exchange rates in the long run, where interest rates are determined in the bond market. The model predicts that an increase in the interest rate differential appreciates the home currency. We test the model for the U.S. dollar against the Deutsche mark, the British pound, the Japanese yen, and the Canadian dollar. The first two pairs of exchange rates—for which purchasing power parity seems to hold—display a strong relationship with interest rate differentials.

This paper empirically examines the long-run relationship between real exchange rates and real interest rate differentials over the recent floating exchange rate period, using a panel cointegration method, with data for a set of industrialized countries. The paper finds evidence of statistically significant long-run relationships and plausible point estimates, which contrasts with much existing evidence. The failure of others to establish such relationships may reflect the estimation method they use rather than any inherent deficiency of the fundamentals-based models.

This paper uses wavelet analysis to investigate the relationship between the spot exchange rate and interest rate differential for seven pairs of countries, with a small country, Sweden, included in each case. The key empirical results show that there tends to be a negative relationship between the spot exchange rate (domestic-currency price of foreign currency) and nominal interest rate differential (approximately the domestic interest rate minus the foreign interest rate) at the shortest timescales, while a positive relationship is more frequently found at the longest timescales. This indicates that among models of exchange rate determination using the asset approach, the sticky-price models are supported in the short run and flexible-price models in the long run.

This book collects together the basic documents of an approach to the theory and policy of the balance of payments developed in the 1970s. The approach marked a return to the historical traditions of international monetary theory after some thirty years of departure from them – a departure occasioned by the international collapse of the 1930s, the Keynesian Revolution and a long period of war and post-war reconstruction in which the international monetary system was fragmented by exchange controls, currency inconvertibility and controls over international trade and capital movements.

We survey the literature on the two main views of exchange rate determination that have evolved since the early 1970s: the monetary approach to the exchange rate (in flex-price, sticky-price and real interest differential formulations) and the portfolio balance approach. We then go on to discuss the extant empirical evidence on these models and conclude by discussing how the future research strategy in the area of exchange rate determination is likely to develop. We also discuss the literature on foreign exchange market efficiency, on exchange rates and ‘news’ and on international parity conditions.

Predicting foreign exchange rates has presented a long-standing challenge for economists. However, the recent advances in computational techniques, statistical methods, newer datasets on emerging market currencies, etc., offer some hope. While we are still unable to beat a driftless random walk model, there has been serious progress in the field. This book provides an in-depth assessment of the use of novel statistical approaches and machine learning tools in predicting foreign exchange rate movement. First, it offers a historical account of how exchange rate regimes have evolved over time, which is critical to understanding turning points in a historical time series. It then presents an overview of the previous attempts at modeling exchange rates, and how different methods fared during this process. At the core sections of the book, the author examines the time series characteristics of exchange rates and how contemporary statistics and machine learning can be useful in improving predictive power, compared to previous methods used. Exchange rate determination is an active research area, and this book will appeal to graduate-level students of international economics, international finance, open economy macroeconomics, and management. The book is written in a clear, engaging, and straightforward way, and will greatly improve access to this much-needed knowledge in the field.

Based on China's experience between 1980 and 2002, a cointegrated vector autoregression model was established to explore the relationships among real interest rates, real exchange rates and balance of payments in China. Taking into account institutional changes, the empirical study shows that significant and usually non-monotonic interactions exist between these three variables. The paper discusses theoretical and policy implications of the empirical result.

Cover -- Rouledge Library Editions : Exchange Rate Economics -- Half Title -- Copyright -- Title -- Copyright1 -- Dedication -- Contents -- Seasonal Movementsof Exchange Ratesand Interest RatesUnder thePre-World War I Gold Standard -- Chapter I Indroduction -- Chapter II The Seasonal Behavior of Interest Rates and Exchange Rates During the Gold Standard-A Review of the Literature -- Introduction I I Interest Rate Seasonality I -- Exchange Rate Seasonality -- Interest Rate Differentials Between the United States and Britain -- Conclusion 4 I Notes -- Chapter III The Effect of Seasonal Endowment Fluctuations in a CASH-in-Advance, Optimizing Model -- Introduction -- Description of Model -- Seller's Currency Model -- Buyer's Currency Model -- Foreign Currency Finance -- Conclusion -- Notes -- Appendix 3-1: List of Symbols -- Appendix 3-2: Tables for Chapter 3 -- Chapter IV An Empirical Investigation of the Seasonal Behavior of Interest Rates and Exchange Rates During the Gold Standard -- Introduction -- Procedure for Modeling Seasonality -- Results of Empirical Investigation -- Summary and Interpretation of Empirical Results -- ~~ 1~ Appendix 4-1: Tables for Chapter 4 -- Appendix 4-2: Figures for Chapter 4 -- Appendix 4-3: Data Sources And Notes -- Chapter V An Empirical Investigation of the Seasonal Behavior of Interest Rate Differentials During the Gold Standard -- Introduction -- Construction of the Interest Rate Differential Series -- Results of Empirical Investigation -- Out-of-sample Forecast Performance -- Seasonal Fluctuations of Interest Differentials: Unexploited Profit Opportunities? -- Conclusion -- Notes -- Appendix 5-1: Tables for Chapter 5 -- Appendix 5-2: Figures for Chapter 5 -- Chapter VI. Conclusion -- References -- Index

How successful is PPP, and its extension in the monetary model, as a measure of the equilibrium exchange rate? What are the determinants and dynamics of equilibrium real exchange rates? How can misalignments be measured, and what are their causes? What are the effects of specific policies upon the equilibrium exchange rate? The answers to these questions are important to academic theorists, policymakers, international bankers and investment fund managers. This volume encompasses all of the competing views of equilibrium exchange rate determination, from PPP, through other reduced form models, to the macroeconomic balance approach. This volume is essentially empirical: what do we know about exchange rates? The different econometric and theoretical approaches taken by the various authors in this volume lead to mutually consistent conclusions. This consistency gives us confidence that significant progress has been made in understanding what are the fundamental determinants of exchange rates and what are the forces operating to bring them back in line with the fundamentals.