Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/152982
Authors: 
Sánchez, Marcelo
Year of Publication: 
2005
Series/Report no.: 
ECB Working Paper 548
Abstract: 
The link between exchange rates and interest rates features prominently in the theoretical and empirical literature on small open economies. This paper revisits this relationship 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 also rise in response to an adverse net export shock in contractionary depreciation cases, and to be lowered in the case of expansionary ones.
Subjects: 
Emerging market economies
exchange rate
monetary policy
transmission mechanism
JEL: 
E52
E58
F31
F41
Document Type: 
Working Paper

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