The Interest Rate-Exchange Rate Link in the Mexican Float

The Interest Rate-Exchange Rate Link in the Mexican Float

Table 1. GMM-estimated, long-run coefficients for the ird model

Instruments: constant, russia, tight (-1 to -3), loose (-1 to -3), ird (-1 to -23),
lns (-1 to -23), lnm (-1 to -23), inflation (to -23), fed (to -23)

Sample: Last week of June 1996-Last week of July 2002

Sample size: 319.

criterion) is -4.9475 with intercept and -4.3463 without it. In both
cases, the MacKinnon critical values reject the unit root hypothesis at
1%. Thus, the residual-based test suggests that (6) is indeed a
cointegration relation.

The next step was the estimation of the ECM (5), from which to
derive an impulse response function. This was carried out by GMM,
for the same sample running from the last week of June 1996 to the
last week of July 2002. The estimated equation passed the tests for
serial error correlation and instruments adequacy; as must be the
case in the presence of cointegration, the error correction coefficient
(lagged five weeks) was negative and statistically significant.

Figure 2 shows the dynamic response of the interest differential
to a permanent depreciation of the exchange rate. As expected, the
figure shows that in the long run the interest rate differential converges
to a rise of about 4.4 points after a 10% exchange rate rise. Moreover,
it shows that the differential overshoots in the initial months.¹⁴ The

¹⁴ To check the statistical significance of this response, the ECM was also estimated in a
transformed version similar to equation (3). This made it possible to test for the significance of
the “long-run” or cumulative effects. The p-value for the sum of the auto-regressive coefficients
was 0.0020, and 0.0381 for the sum of exchange rate coefficients.

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