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 |
| _version_ | 1818958972497952768 |
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| author | Jón Helgi Egilsson |
| author_facet | Jón Helgi Egilsson |
| author_sort | Jón Helgi Egilsson |
| collection | DOAJ |
| description | 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. |
| first_indexed | 2024-12-20T11:34:14Z |
| format | Article |
| id | doaj.art-fb995b86c3674f7293d6579b082e10f5 |
| institution | Directory Open Access Journal |
| issn | 1514-0326 1667-6726 |
| language | English |
| last_indexed | 2024-12-20T11:34:14Z |
| publishDate | 2020-01-01 |
| publisher | Taylor & Francis Group |
| record_format | Article |
| series | Journal of Applied Economics |
| spelling | doaj.art-fb995b86c3674f7293d6579b082e10f52022-12-21T19:42:10ZengTaylor & Francis GroupJournal of Applied Economics1514-03261667-67262020-01-0123145046810.1080/15140326.2020.17955261795526How raising interest rates can cause inflation and currency depreciationJón Helgi Egilsson0Faculty of Economics, University of IcelandIn 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.http://dx.doi.org/10.1080/15140326.2020.1795526exchange rateexchange rate modelinginterest ratesinterest rate differentialirdmonetary policycontrol ratescash-in-advancecentral bank policyuncovered interest rate parityuipcarry tradefactor price equalization |
| spellingShingle | Jón Helgi Egilsson How raising interest rates can cause inflation and currency depreciation Journal of Applied Economics exchange rate exchange rate modeling interest rates interest rate differential ird monetary policy control rates cash-in-advance central bank policy uncovered interest rate parity uip carry trade factor price equalization |
| title | How raising interest rates can cause inflation and currency depreciation |
| title_full | How raising interest rates can cause inflation and currency depreciation |
| title_fullStr | How raising interest rates can cause inflation and currency depreciation |
| title_full_unstemmed | How raising interest rates can cause inflation and currency depreciation |
| title_short | How raising interest rates can cause inflation and currency depreciation |
| title_sort | how raising interest rates can cause inflation and currency depreciation |
| topic | exchange rate exchange rate modeling interest rates interest rate differential ird monetary policy control rates cash-in-advance central bank policy uncovered interest rate parity uip carry trade factor price equalization |
| url | http://dx.doi.org/10.1080/15140326.2020.1795526 |
| work_keys_str_mv | AT jonhelgiegilsson howraisinginterestratescancauseinflationandcurrencydepreciation |