The Interest Rate-Exchange Rate Link in the Mexican Float
float.1 But it is also possible to judge the regime’s performance
according to other conventional criteria. For instance, it is
interesting to note that the current system has not eliminated the
phenomenon of recurring periods of real currency appreciation.2 It
can also be noted that the volatility of both the exchange rate and
the interest rate increased after the regime shift, in contrast to the
prediction of traditional theory.3 In a sense, this is not surprising:
as recent empirical research has shown, actual floats tend to diverge
from the textbook model in ways that make it difficult to distinguish
between de jure floats and heavily managed exchange rate regimes
(see Calvo 2000, Calvo and Reinhart 2002, and Hausmann et al.
1999 and 2000).
In terms of macroeconomic management, one of the potential
benefits of a floating exchange regime is that it may allow a country to
have an autonomous monetary policy despite being in an environment
of high international mobility of capital; this stands in contrast to the
case of a fixed exchange rate system, in which the international
equalization of returns forced by arbitrage entails the equalization of
local and foreign currency interest rates (up to some risk premium).
The possibility of having an autonomous monetary policy depends
crucially, however, on the way interest rate differentials respond to
exchange rate changes. In this regard, it is conventionally assumed
that an exogenous rise in the exchange rate (a decline in the value of
the local currency) should lead to a fall in the expected depreciation
rate, and thus, through arbitrage, a fall in local interest rates. This
opens the possibility of a trade-off between the levels of the exchange
rate and the interest rate that can be exploited by monetary policy.
This kind of link has also the implication that a float may exhibit
1 This idea underlies much of the recent debate on the so-called “two corners” approach to
the choice of exchange rate regime in developing countries. See Edwards (2001) for an overview.
2 As shown by the 33% increase in the National Institute of Statistics (INEGI) moving-
average index of dollar unit labor cost in the manufactures, between January 1998 and December
2002. On the other hand, the most recent record (as of early 2003) indicates that, with the float,
the eventually necessary upward adjustment in the exchange rate has been much less disrupting
than what was observed in previous episodes featuring a fixed or predetermined rate (although
the overall macroeconomic setting has also been more favorable).
3 The exchange rate’s average monthly change (in absolute terms) moved from 1.02% during
January 1992-December 1994, to 1.51% during January 1996-October 2001. At the same time,
the average change for the real interest rate increased from 1.2 percentage points to 2.15 points
(see Ibarra 2002). Martmez et al., (2001) show that, although the volatility of the peso’s exchange
rate has been similar to that of other major floaters, interest rate volatility has been much
higher, even after excluding 1995 data from calculation. The same conclusion emerges from
Calvo and Reinhart (2002) data.