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An investigation of the causal relations between exchange rates and interest rate differentials using wavelets

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  • Hacker, R. Scott
  • Karlsson, Hyunjoo Kim
  • Månsson, Kristofer

Abstract

This paper uses wavelet analysis to investigate causality between the spot exchange rate and the nominal interest rate differential for seven country pairs, which includes Sweden. 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 strengthening evidence of the nominal interest rate differential Granger causing the exchange rate as the wavelet time scale increases. 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 (i.e. an increase in the Swedish interest rate compared to that of another country is associated with a lower Swedish krona price of the other country's currency) and more positive relationships at the longer time scales.

Suggested Citation

  • Hacker, R. Scott & Karlsson, Hyunjoo Kim & Månsson, Kristofer, 2014. "An investigation of the causal relations between exchange rates and interest rate differentials using wavelets," International Review of Economics & Finance, Elsevier, vol. 29(C), pages 321-329.
    • Handle: RePEc:eee:reveco:v:29:y:2014:i:c:p:321-329
    DOI: 10.1016/j.iref.2013.06.004
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    More about this item

    Keywords

    Exchange rate; Interest rate differential; Granger causality; Wavelet analysis; Uncovered interest rate parity;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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