The Interest Rate-Exchange Rate Link in the Mexican Float

Carlos A. Ibarra

not to study how the interest rate-exchange rate link evolves as a
result of policy actions, but rather to analyze how private expectations
(and perhaps risk assessments) change following an exchange rate
variation.

The last section of the paper offers an initial formal exploration of
the possibility that the dynamic response of the interest rate
differential reflects private anticipations of future monetary policy
actions, à la McCallum (1994). The basic idea is that if the central
bank exhibits inflation aversion, and there is a positive relation
between the exchange rate and the inflation rate, then agents may
expect a policy tightening in the aftermath of an exogenous exchange
rate depreciation. According to conventional term structure theory,
this sole anticipation would tend to raise current and future interest
rates, even if no central bank action actually takes place. Even more,
it is also noted that if the central bank were to choose an alternative
course of action, then there could be destabilizing effects on the assets
market, given the concurrence of expectations of currency depreciation
and falling interest rates.

References

Bansal, R. and M. Dahlquist (2000), “The forward premium puzzle:
different tales from developed and emerging economies”, Journal
of International Economics, num. 51, pp. 115-144.

Berg, A. and E. Borensztein (2000), “The pros and cons of full
dollarization”, IMF, Working Paper, num. 00/50.

Bertola, G. and L. E. O. Svensson (1993), “Stochastic devaluation risk
and the empirical fit of target-zone models”, Review of Economic
Studies, vol. 60, pp. 689-712.

Calvo, G. (2000), “Capital markets and the exchange rate. With special
reference to the dollarization debate in Latin America”, University
of Maryland, manuscript, April.

— (1997), “Monetary and exchange rate policy for Mexico. Key issues
and a proposal”, University of Maryland, manuscript, June.

— and C. M. Reinhart (2002), “Fear of floating”, The Quarterly Journal
of Economics, 117 (2), pp. 379-408.

Carstens, A. and A. Werner (1999), “Mexico’ monetary framework under
a floating exchange rate regime”, Banco de México, Research Paper,
num. 99/05.

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