How raising interest rates can cause inflation and currency depreciation
In this paper we derive a new model on exchange rate response to a lasting higher interest rate level. Contemporary models do not provide a convincing explanation for this relationship, but recent research suggests that models based on demand-pull effects to be somewhat confined to small funding cos...
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| Format: | Article |
| Language: | English |
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Taylor & Francis Group
2020-01-01
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| Series: | Journal of Applied Economics |
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| Online Access: | http://dx.doi.org/10.1080/15140326.2020.1795526 |
| Summary: | In this paper we derive a new model on exchange rate response to a lasting higher interest rate level. Contemporary models do not provide a convincing explanation for this relationship, but recent research suggests that models based on demand-pull effects to be somewhat confined to small funding cost increases. This would make cost-push effects more relevant when the interest rate differential (IRD) is larger and longer-lasting. The new model accounts for cost-push effects and suggests that a persistent higher IRD can evoke multiple responses, including currency depreciation, specialization, inflation, and wage drift. The model suggests that excessive long-lasting IRD can spark a chronic interaction between inflation and currency depreciation. Empirical data substantiate the prediction capability of the new model. We also demonstrate how the uncovered interest rate parity (UIP) principle is a special case, which can explain its empirical research anomalies, and when carry trade is a profitable investment strategy. |
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| ISSN: | 1514-0326 1667-6726 |