Do Interest Rates Affect the Exchange Rate under Capital Controls? An event study of Iceland’s experience with capital controls

We find that both actual changes and unexpected changes in interest rates affect the average exchange rate in Iceland when the year 2009 is included in the sample that ends in August of this year but not when it is excluded. This early period was characterized by lax capital controls until the autumn of 2009. It follows that, given the moderate changes of interest rates observed in the data, using interest rates to stabilise the exchange rate may work when the capital controls are not effectively enforced but is not as useful when they are enforced. However, it should be noted that large changes in interest rates may have an effect on exchange rates when capital controls are enforced, although such changes never occurred during our sample period.