The Interest Rate-Exchange Rate Link in the Mexican Float
There is a large body of literature that studies the interest rate-
exchange rate link, with particular emphasis on testing the validity
of the uncovered interest parity condition. A stylized fact from much
of this work is the existence of a negative correlation between current
interest rate differentials and future exchange rate variations, against
what the parity condition would predict.16 Several explanations have
been put forward, including the existence of a time-varying currency
risk premium (for critical assessments, see Takagi 1991 and Svensson
1992), realignment risk in the context of exchange bands (see Bertola
and Svensson 1993), and bandwagon effects in the formation of
expectations (see Takagi 1991).
Related work has advanced the idea that governments typically
show “fear of floating”, in the sense that they use monetary policy to
stabilize exchange rates (see references to work by Calvo, Hausmann
et al. in the introduction). This could produce a positive correlation
between domestic interest rates and the level of the exchange rate. In
fact, McCallum (1994) had argued that the frequently observed
negative association between current interest rate differentials and
next-period exchange rate variations can be rationalized by assuming
the existence of a government policy reaction function, by which local
interest rates are raised in response to a weakening in the currency’s
international value. McCallum (1994) simply assumes that
governments try to smooth exchange rate variations; in what follows,
we will take for granted that there is some degree of pass-through
from the exchange rate to domestic inflation, and that inflation-averse
authorities may thus respond to a rise in the exchange rate by
tightening monetary policy.17
A formal exposition of the problem is as follows. By definition,
the proportional change in the real exchange rate (defined as the
ratio of foreign to local prices, in local currency) is equal to the
proportional change in the nominal exchange rate minus the
domestic inflation rate (assuming for simplicity that foreign
16 See Froot and Thaler (1990) and Sarno and Taylor (2001) for an overview. Nakagawa
(2002) and Obstfeld and Taylor (2001) show that the so-called forward premium puzzle may
reflect the presence of nonlinearities in the relationship between exchange and interest rates,
while Bansal and Dahlquist (2000) argue that in fact no such puzzle can be detected in the data
for developing countries.
17 Clarida (2001) summarizes recent empirical work showing that the central bank, in a
number of developed countries, incorporates the exchange rate in its policy reaction function.
Eichengreen (2001) argues that inflation-targeting central banks will react by tightening policy
after the local currency depreciates as a result of capital account shocks.
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