Carlos A. Ibarra
automatic output stabilizing properties in the presence of capital
account shocks, as explained below.
The purpose of this paper is to analyze the actual way interest
rate differentials have reacted to variations in the exchange rate during
the floating regime currently in operation in Mexico. This is done by
means of an Error Correction Model (ECM) for the interest rate gap
between Mexican and US Treasury bills. The model is estimated by
the Generalized Method of Moments (GMM) to allow for the possible
endogeneity of regressors. As it turns out, the estimation results show
a positive correlation between current exchange rate changes and
future variations in the interest rate differential.
The rest of the paper is structured as follows. The first section
considers in more detail the macroeconomic implications of the interest
rate-exchange rate link, providing motivation for the empirical
analysis, and also an analytical framework to appreciate the main
implications from the econometric results. The estimation results from
the ECM for the peso-dollar interest rate differential are presented in
section II together with the estimated impulse response function that
describes the differential’s dynamic response to a permanent change
in the peso-dollar exchange rate. Section III considers a possible
explanation for the findings, while section IV concludes with a
summary of results.
I. Macro effects of the interest rate-exchange rate link
Consider the textbook case of an individual deciding whether to buy a
peso- or alternatively a dollar-denominated bond with the same
maturity. The return (in local currency) for the first option would be
the current peso interest rate: i, while in the latter it would correspond
to the sum of the dollar interest rate and the peso’s expected
depreciation rate against the dollar: i*+ e. In this context, the expected
depreciation rate is equal to the proportional change in the present
exchange rate expected for the length of the bond holding period.
Under conditions of high capital mobility, arbitrage ensures the
existence of a strong link between the return on the two assets. Thus,
it is possible to write an equilibrium condition of the form:
(1) i = i* + e + d,