The Relationship between Exchange Rates and Interest Rate Differentials: A Wavelet Approach

Abstract

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.

Investigating the co‐movement between exchange rates and interest rates in the bi‐variate form: Evidence from Turkey

“…The negative relationship in the short run confirms the sticky price models. The results in both the short term and long term are consistent with (Andrieș et al, 2017; Scott Hacker et al, 2012) who found a positive relationship in the long term and a negative relationship in the short term.…”

“…It can be observed that in mid‐2006 between 2 and 4 scales the arrows are right‐downward oriented, while in the same time for scales 16 to 32 the arrows are left‐upward oriented, which means that the interest rate is leading while the exchange rate is lagging. Figure 3 provides evidence for the existence of a bidirectional relationship between exchange rate and interest rate, and these results are consistent with Scott Hacker et al (2012) and Andrieș et al (2017).…”

“…The results show the significant intervention of monetary policy in this period; significantly, in terms of the overnight interest rate situation of the mystery was facing the world as a result of this crisis. The results indicate that the monetary policy procedure has a more significant effect on the exchange rate in the long term (high‐frequency) than in the short‐run (low frequency) and the effects of the monetary policy procedures appear in the long run (high frequency) the existing relationship between exchange rate and the interest rate goes in line with Andrieș et al (2017); Hameed and Rose (2018); Özmen and Yılmaz (2017); Scott Hacker et al (2012).…”

“…The study showed that there is no evidence that interest rate differentials caused spot exchange rates at all horizons except for some subsamples for Malaysia. On the contrary, Scott Hacker, Karlsson, and Månsson (2012) investigated the relationship between spot exchange rate and nominal interest rate differential by using wavelet analysis. The study spot exchange rates of five major currencies against the Swedish Krona.…”

The nexus between the exchange rates and interest rates: evidence from BRIICS economies during the COVID-19 pandemic

“…Most of the empirical literature on the UIP hypothesis is concentrated in favour of developed economies (Chinn and Meredith, 2004, 2005; Engel, 2016; Ismailov and Rossi, 2018; Juselius and Assenmacher, 2017; Lothian, 2016; Golit et al , 2019), with relatively scanty literature in case of emerging economies (Beng and Le Ying, 2000; Sanchez, 2008; Jackman et al , 2013; Vithessonthi, 2014; Mladenović and Rašković, 2018). Further, one strand of literature has focused on examining the links between interest rates and exchange rates using wavelet transforms (Andrieș et al , 2017; Hacker et al , 2012; Hacker et al , 2014; Saiti et al , 2016) and DCC modelling (Bautista, 2003). Another strand of literature has considered the lagged relationships by implementing Granger causality models (Clarida and Gali, 1994; Cheng, 1999; Engel and West, 2005; Gumus, 2002; Si et al , 2018).…”