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 217: The Relationship between Exchange Rates and Interest Rate Differentials: a Wavelet Approach

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: This paper uses wavelet analysis to investigate the relationship between the spot exchange rate and the interest rate differential for seven pairs of countries, with a small country, Sweden, included in each of the cases. The key empirical results show that there tends to be a negative relationship between the spot exchange rate (domestic-currency price of foreign currency) and the nominal interest rate differential (approximately the domestic interest rate minus the foreign interest rate) at the shortest time scales, while a positive relationship is shown at the longest time scales. This indicates that among models of exchange rate determination using the asset approach, the sticky-price models are supported in the short-run while in the long-run the flexible-price models appear to better explain the sign of the relationship.

Keywords: exchange rates; interest rate differential; uncovered interest parity; monetary approach; small-economy; wavelet analysis

JEL-codes: E44; F31; F42

23 pages, February 11, 2010

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