The Interest Rate-Exchange Rate Link in the Mexican Float
where d is by definition an equilibrium return differential or risk
premium. With perfect capital mobility, d will be zero and (1) will
simplify to the (uncovered) interest parity condition.
A floating exchange regime will allow a country to have an
autonomous monetary policy, despite the equalization of returns
forced by the international mobility of capital and for a given level
of the risk premium, by adjustments in the expected depreciation
rate. Assume the authorities adopt an expansionary policy stance,
say through an open market purchase of peso bonds. The peso
interest rate will tend to fall, thus creating an excess demand for
dollars; if the authorities do not intervene in the exchange market,
this excess demand will result in a weakened currency (an exchange
rate rise).
The key point is how this currency depreciation would restore
equilibrium condition (1). A standard assumption in the analytical
literature is that the exchange rate rise reduces the gap between the
current rate and the level of the exchange rate expected for some future
period, thus bringing about the required fall in the expected
depreciation rate. The reasoning implicitly assumes that the expected
exchange rate is independent of the current rate (or that, if it moves,
it does so less than proportionally). This is, for instance, the mechanism
in Dornbusch’s classic 1976 model: a permanent monetary expansion
increases the expected exchange rate in the same proportion, and thus
the exchange rate has to overshoot in the short run to restore asset
market equilibrium.4
Thus, for a given level of the risk premium, an autonomous
monetary policy is possible because the rise in the exchange rate
reduces depreciation expectations and this tends to lower the local
currency interest rates. The prediction is that there should be a
negative relationship between the exchange rate and the interest rate.
To further appreciate the macroeconomic role of this link, consider
the case of a capital account shock. In particular, assume that there is
an exogenous fall in the world demand for local bonds. The ensuing
capital outflow in the balance of payments will tend to depress domestic
output, while the reduced demand for local assets will weaken the
4 If there is a high degree of capital mobility, but domestic and foreign assets are imperfect
substitutes, then in general d will be different from zero, and its size will be positively affected
by the relative supply of peso assets. This creates the possibility of a second adjustment
mechanism. The central bank’s purchase of bonds will reduce the stock of peso bonds available
to the private sector, exerting in this way downward pressure on the risk premium.