Scandinavian Working Papers in Economics

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

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

Scott Hacker (), Hyunjoo Kim and Kristofer Månsson
Additional contact information
Scott Hacker: Jonkoping International Business School
Hyunjoo Kim: Jonkoping International Business School
Kristofer Månsson: Jonkoping International Business School

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

JEL-codes: C32; E44; F31; F42

20 pages, February 11, 2010

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