Revisiting the interest rate–exchange rate nexus: a Markov-switching approach

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.     

Central Bank Behavior, the Institutional Framework, and Policy Regimes: Inflation Versus Noninflation Targeting Countries

This article estimates central bank reaction functions for 20 OECD countries. It bridges the gap between the Taylor reaction function literature and the political-economy literature. Central banks react to both inflation and the output gap. Moreover, inflation-targeting countries have been able to reduce nominal interest rate to a greater extent than have non-inflation-targeting countries. Countries with fixed exchange rates react more strongly to inflation but not at all to the output gap, unlike countries with floating rates. Political influences also seem relatively more important in fixed exchange rate countries. Central bank independence also helps reduce nominal interest rates. (JEL E58 , C31 , C32 , C53 )     

Convergence of interest rates around the Pacific Rim

This article applies the panel data unit root tests provided by Im, Pesaran and Shin (Discussion paper, 1997) to examine the interest rate convergence of small-open Asian countries with major financial centres. With monthly data from 1988:1 to 1997:6, it was found that the nominal interest rates of these countries converge to the US rates rather than to Japan's. This finding is consistent with the view that the monetary authorities of non-Japan Asian economies pegged their exchange rates overwhelmingly to the dollar rather than the yen before the financial crisis of 1997.     

Modifying Taylor reaction functions in the presence of the zero‐lower‐bound — Evidence for the ECB and the Fed

We propose an alternative way of estimating Taylor reaction functions if the zero‐lower bound on nominal interest rates is binding. This approach relies on tackling the real rather than the nominal interest rate. So if the nominal rate is (close to) zero central banks can influence the inflation expectations via quantitative easing. The unobservable inflation expectations are estimated with a state‐space model that additionally generates a time varying series for the equilibrium real interest rate and the potential output — both needed for estimations of Taylor reaction functions. We test our approach for the ECB and the Fed within the recent crisis. We add other explanatory variables to this modified Taylor reaction function and show that there are substantial differences between the estimated reaction coefficients in the pre‐ and crisis era for both central banks. While the central banks on both sides of the Atlantic act less inertially, put a smaller weight on the inflation gap, money growth and the risk spread, the response to asset price inflation becomes more pronounced during the crisis. However, the central banks diverge in their response to the output gap and credit growth.     

EXCHANGE RATE STABILISATION, LEARNING AND THE TAYLOR PRINCIPLE

The paper explores whether central banks can keep their interest rates independent from given foreign rates, and to what extent interest policies designed to stabilise nominal exchange rate changes can be applied instead of, or in addition to, the traditional interest rate response to inflation gaps. This modification of a Taylor Rule is analysed in a simple macro model with some New Keynesian features. Information is imperfect; agents cannot build rational expectations but try to learn 'true' market relations. Results show that the Taylor Principle can be generalised in an open economy with flexible exchange rates.     

Macroeconomic Fragility and Exchange Rate Vulnerability: A Cautionary Record of Transition Economies

The interaction between the exchange rate regime and macroeconomic stabilization in several transition economies during 1990–1996 was influenced by the persistence of high inflation rates and the initial disequilibrium between the highly undervalued nominal exchange rates in relation to their purchasing power parity estimates. Policymakers generally adopted the flexible (nominal) exchange rate regimes for manipulating real exchange rates with a view to correcting the exchange rate disequilibrium and conveying inflation control signals. The rates of real appreciation were higher in the earlier years of high inflation rates. By 1996, lower inflation rates required less currency appreciations thereby reducing the negative impact of the latter on trade competitiveness. However, the persistence of unwarranted interest rate differentials, a consequence of the domination of monetary control over prudent fiscal management, and the associated inflows of foreign funds put an upward pressure on exchange rates exacerbating trade competitiveness. The transition record suggests that innovative exchange rate arrangements can provide only a brief interval during which sound fiscal discipline needs to be put in place for controlling inflation.J. Comp. Econom.,December 1998, 26(4), pp. 621–641. Columbia University, New York, New York 10027.     

Uncovering the link between a flexible exchange rate and fundamentals: the case of Central and Eastern European economies

This article examines the link between a nominal exchange rate and macrofundamentals in Central and Eastern European (CEE) countries. We use the model based on the monetary policy rule as a theoretical framework that explains the relations between the exchange rate and price level, risk premium, output gap, and expected inflation. It allows for endogeneity of the monetary policy – the issue ignored in the widely used monetary model. The sample covers the period January 2000 – December 2014, so the data are not plagued by high-inflation differentials characteristic for the early transition period and include countries with relatively flexible exchange rates. Our empirical strategy employs the panel error correction model that allows for cross-sectional dependence and a series of panel causality tests. The main finding is that the nominal exchange rates in CEE countries are not disconnected from macrofundamentals implied by the Taylor rule-based model. More specifically, we find that there is a strong cross-sectional dependence among CEE countries, exchange rates Granger-cause macrofundamentals and tend to revert to the long-run relation, and that the results are robust to the ‘extraordinary circumstances’ argument, i.e. do not rest on the dynamics during the global financial crisis.     

The Global Financial Crisis and Stochastic Convergence in the Euro Area

This paper analyzes the issue of convergence in the original Euro Area countries, and assesses the effect of the global financial crisis on the process of convergence. In particular, we consider whether the global financial crisis pulled the 12 economies of the Euro Area together or pushed them apart. We investigate the dynamics of stochastic convergence of the original Euro Area countries for inflation rates, nominal interest rates, and real interest rates. We test for convergence relative to Germany, taken as the benchmark for core EU standards, using monthly data over the period January 2001 to September 2010. We examine, in a time-series framework, three different profiles of the convergence process: linear convergence, nonlinear convergence, and linear segmented convergence. Our findings both contradict and support convergence. Stochastic convergence implies the rejection of a unit root in the inflation rate, nominal interest rate, and real interest rate differentials. We find that the differentials are consistent with a unit-root hypothesis when the alternative hypothesis is a stationary process with a linear trend. We frequently, but not always, reject the unit-root hypothesis when the alternative is a stationary process with a broken trend. We also note that the current financial crisis plays a significant role in dating the breaks.     

Are there bubbles in Chinese RMB–dollar exchange rate? Evidence from generalized sup ADF tests

This article uses recently developed generalized sup ADF (GSADF) unit root tests into the analysis of nominal RMB–dollar exchange rates bubbles. Based on the results from the GSADF tests, we find strong evidence of explosive behaviour in the nominal exchange rate and investigate two bubbles there. The first bubble is during 2005–2006 which is determined neither by the relative prices of traded goods nor the relative price of nontraded goods. The second bubble busts in 2008 during subprime crisis period, and which is determined by the relative prices of traded goods but not the relative price of nontraded goods. There is no bubble before 2005 as the exchange rate is under fixed regime. As for this result, some expansionary monetary and fiscal policies are required in China since these are the most efficient and effective under a bubble burst scenario.     

Open-Economy Macroeconomics: Developments in Theory and Policy

This paper views developments in open-economy macroeconomics through the lens of the debate over European monetary unification. The empirical tendency for nominal exchange rate regimes to affect the variability of nominal and real exchange rates alike can be rationalized by sticky-price theories or models of asset-market liquidity effects. But plausible liquidity models have difficulty generating enough persistence to match the data. Thus, the macroeconomic stabilization costs of forgoing the exchange-rate realignment option seem pertinent. It is argued that our theories of efficiencies due to a common currency remain unsatisfactory, despite recent advances. The paper concludes by reviewing theories of currency crisis     

Debt, liquidity and dynamics

Summary. Money, which provides liquidity, is distinct from debt. The introduction of a bank that issues money in exchange for debt and pays out its profit as dividend to shareholders modifies the model of overlapping generations. The set of equilibrium paths, their dynamic properties, as well as the scope and effectiveness of monetary policy are significantly altered: though low rates of interest are associated with superior steady state allocations, stability of the steady state may require a nominal rate of interest above a certain minimum: without production, a decrease in the nominal rate of interest may result in explosive behavior or convergence to an endogenous cycle, while in an economy with production, an increase in the nominal rate of interest may lead to indeterminacy and fluctuations.Received: 5 October 2004, Revised: 5 November 2004 JEL Classification Numbers: E30, E32, E50, E52.C. Rochon, H.M. Polemarchakis: We thank Jean-Michel Grandmont for helpful comments. Correspondence to: C. RochonThis revised version was published online in May 2005 with a corrected abstract.     

State prices,liquidity, and default

We show, in a monetary exchange economy, that asset prices in a complete markets general equilibrium are a function of the supply of liquidity by the Central Bank, through its effect on default and interest rates. Two agents trade goods and nominal assets to smooth consumption across periods and future states, in the presence of cash-in-advance financing costs that have effects on real allocations. We show that higher spot interest rates reduce trade and as a result increase state prices. Hence, states of nature with higher interest rates are also states of nature with higher risk-neutral probabilities. This result, which cannot be found in a Lucas-type representative agent model, implies that the yield curve is upward sloping in equilibrium, even when short-term interest rates are fairly stable and the variance of the (macroeconomic) stochastic discount factor is 0. The risk-premium in the term structure is, therefore, a monetary-cost risk premium.     

人民币汇率、资产价格与短期国际资本流动

本文基于1999年1月～2008年6月的月度数据,运用ARDL-ECM模型检验了人民币汇率、资产价格与我国短期国际资本流动的关系。结果表明,长期内,人民币汇率预期变化率和国内外利差是影响短期国际资本流动的显著因素,人民币汇率水平、国内股市收益率和房地产收益率并未对短期国际资本流动产生显著影响;短期内,人民币汇率、国内外利差和房地产收益率对短期国际资本流动有显著的滞后效应。     

On the Exchange Rate as a Nominal Anchor: The Rise and Fall of the Credibility Hypothesis

The credibility hypothesis, which was used to support the use of a pegged exchange rate arrangement as a nominal anchor mechanism, is based on restrictive analytical foundations that circumscribe its real world applicability. While all pegged exchange rate arrangements are subject to circumstances that can undermine the sustainability of the peg, exchange rate nominal anchor pegs are especially fragile because such arrangements introduce problems that are endogenous to that particular type of regime. The East Asian crisis is used to demonstrate the fragility of exchange rate nominal anchor pegs, while the case of Australia demonstrates how a floating currency escaped the contagion of the East Asian crisis.     

Monetary Policy in the Aftermath of Currency Crises: The Case of Asia

The paper evaluates monetary policy and its relationship with the exchange rate in the five Asian crisis countries. The findings are compared with previous currency crises in recent history. It is found that there is no evidence of overly tight monetary policy in the Asian crisis countries in 1997 and early 1998. There is also no evidence that high interest rates led to weaker exchange rates. The usual tradeoff between inflation and output when raising interest rates suggested the need for a softer monetary policy in the crisis countries to combat recession. However, in some countries, corporate balance sheet considerations suggested the need to reverse overly depreciated currencies through firmer monetary policy.     

Economy as Instituted Process: Change,Transformation, and Progress

During the past two decades, chronic fiscal deficits have led to elevated and rising ratios of government debt to nominal GDP in Japan. Nevertheless, long-term Japanese government bonds' (JGBs) nominal yields initially declined, and have since stayed remarkably low and stable. This is contrary to the received wisdom which holds that higher government deficits and indebtedness will exert upward pressures on nominal yields. This paper examines the relationship between JGBs' nominal yields and short-term interest rates, as well as other factors, such as low inflation, persistent deflationary pressures, and tepid growth. We also argue that Japan has monetary sovereignty, which gives the Japanese government the ability to service its debt, and enables the Bank of Japan (BOJ) to keep JGBs' nominal yields low by ensuring that short-term interest rates are low, and by using various other tools of monetary policy. The argument that short-term interest rates and monetary policy are the primarily drivers of long-term interest rates follows John Maynard Keynes's (1930) insights.     

Time-Varying Risk, Interest Rates, and Exchange Rates in General Equilibrium

Under mild assumptions, the data indicate that fluctuations in nominal interest rate differentials across currencies are primarily fluctuations in time-varying risk. This finding is an immediate implication of the fact that exchange rates are roughly random walks. If most fluctuations in interest differentials are thought to be driven by monetary policy, then the data call for a theory which explains how changes in monetary policy change risk. Here, we propose such a theory based on a general equilibrium monetary model with an endogenous source of risk variation—a variable degree of asset market segmentation.     

Value,Distribution and Capital: A review essay

This article identifies two possible alternative approaches to questions of exchange rate policy within a broadly keynesian frame work. One argument is that the implementation of keynesian’ policies in single jurisdiction requires a ‘managed’ or ‘dirty’ float, while the other would stress the benefits of a greater degree of nominal exchange rate stability as a means of reducing uncertainty and the volatility of expectations. We argue in favour of the former, on the grounds that it will not be possible to pursue a lsquo;cheap money’ policy to reduce real interest rates in a single jurisdiction unless there is some room to manoeuvre on exchange rates. A ‘fixed but adjustable’ exchange rate regime is less attractive because of the potential for deflationary bias in a hegemonic system with fixed exchange rates. Also, the politicization of exchange rate policy in such an environment makes necessary adjustments, particularly in a reflationary direction, more difficult than they otherwise would be. The recent history of the ERM in Europe provides examples of both phenomena.     

Real and nominal UK interest rates,ERM membership,and inflation targeting

This article estimates a two-factor term structure model to analyze the time-varying mean-reverting levels of the UK real and nominal short-term interest rates. Before and during British membership in the ERM, the mean-reverting levels of real and nominal short rates have a strong negative correlation. Afterward, when the UK implemented an inflation targeting policy, the mean-reverting levels have a strong positive correlation. The article also reports empirical evidence of a link between the time-varying central tendencies and inflation in the disinflation period before the implementation of the inflation targeting policy.     

Capital Inflows,Dutch Disease Effects,and Monetary Policy in a Small Open Economy

This paper studies the role of monetary policy in a small open economy that experiences Dutch disease effects as a result of capital inflows, and examines the issue of whether such a policy should seek to address these effects from a welfare perspective. I find that Dutch disease effects occur under a fixed nominal exchange rate regime. However, a monetary policy regime characterized by generalized Taylor interest rate rules featuring either the real exchange rate or the nominal exchange rate avert Dutch disease effects. Welfare results reveal that the optimal rule is a generalized Taylor rule consistent with nominal exchange rate flexibility.