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CESIS - Centre of Excellence for Science and Innovation Studies, Royal Institute of Technology KTH/CESIS Working Paper Series in Economics and Institutions of Innovation

No 215:
An Investigation of the Causal Relations between Exchange Rates and Interest Rate Differentials Using Wavelets

Scott Hacker (), Hyunjoo Kim and Kristofer Månsson

Abstract: Monthly and quarterly data for the spot exchange rate of the Swedish Krona against major currencies have been used in this paper to investigate the causality in a Granger sense at different time scales between the spot exchange rate and the nominal interest rate differential by using wavelet analysis. Impulse response functions are also utilized to examine the signs of how one of these variables affects the other over time. One key empirical finding from the causality tests is that there is only substantial evidence of a causal relationship in the long run between the two variables. When using monthly data, this is true in both directions. When considering impulse responses on how the interest rate differential affects the exchange rate, there appears to be some evidence of more negative relationships at the shorter time scales and more positive relationships at the longer time scales.

Keywords: exchange rate; interest rate differential; Granger causality; wavelet analysis; uncovered interest rate parity; (follow links to similar papers)

JEL-Codes: C32; E44; F31; F42; (follow links to similar papers)

20 pages, February 11, 2010

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