The Interest Rate-Exchange Rate Link in the Mexican Float

The Interest Rate-Exchange Rate Link in the Mexican Float

together with the rates of inflation and currency exchange (pesos per
dollar; the series are precisely defined below, in Subsection IIc). There
are two important observations to make: the first is that the interest
rate differential is strongly trended, and that the trend appears to be
determined by the inflation rate (with transitory departures caused
by phenomena such as the Russian crisis of August 1998). In terms of
Equation (1), this observation suggests that, in the long run, the
expected depreciation rate is determined by the domestic inflation
rate, perhaps because expected inflation is, to an important extent,
determined by current inflation.

60

Figure 1. Interest rate differential, and inflation and exchange rates.

11.0

exchange rate (rhs scale)

10.0

50 -%

40

30

20 -

10

9.0

8.0

co

7.0

6.0

01⁰/04/1996 01/02/1997 31/12/1997 31/12/1998 30/12/1999 28/12/2000 27/12/2001
week

A second feature to note is the strong positive contemporaneous
correlation between the interest differential and the exchange rate,
presumably as a reflection of the presence of capital account shocks.⁷
In this case, an exogenous rise in the world demand for peso assets,
for instance, would simultaneously strengthen the currency and push
local interest rates down. This observation implies that any possibility
of finding a negative relationship will depend on including a long lag

⁷ It may be important to note that during this period the domestic interest rate under
study was not a direct instrument in the Banco de Mexico’s policy rule, but a market-determined
variable (subject, of course, to influence from central bank actions).

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