Interest rate and exchange rate policies

Topics: Foreign exchange market, Monetary policy, Currency Pages: 21 (4201 words) Published: February 25, 2014





SEMESTER 1, 2013/2014





Table of Contents


ADFAugmented Dickey Fuller
AICAkaike Information Criterion
AUDAustralian Dollar
FPMFlexible Price Monetary Model
LRLikelihood Ratio
NZDNew Zealand Dollar
PBTPortfolio Balance
PPPPurchasing Power Purchase Agreement
RBAReserve Bank of Australia
RIRDReal Interest Rate Differential Model
SBCSchwarc Bayesian Criterion
SPMSticky Price Monetary Model


Figure 1: Australian Fixed Interest Rates
Figure 2: Exchange Rates and Relative Prices
Figure 3: Official Reserve Assets
Figure 4: Selected Asian Currencies against the US Dollar
Figure 5: Australian Dollar

Figure 6: Australian Interest Rate and Exchange Rate Volatility

Figure 7: New Zealand Dollar Exchange rate & trade-weighted index

Figure 8: Figure 8: Nominal and real exchange rates


Table 1: Augmented Dickey Fuller (ADF) Test Statistic for Australia Table 2: Augmented Dickey Fuller (ADF) Test Statistic for New Zealand

Table 3: Co -integration LR Test Based on Maximal Eigen value for Australia

Table 4: Co-integration LR Test Based on Trace for Australia.

Table 5: Co-integration LR Test Based on Maximal Eigen value for New Zealand

Table 6: Co-integration LR Test Based on Trace for New Zealand Table 7: Granger Causality Test for Australia
Table 8: Granger Causality Test for New Zealand


In this paper study aims to investigate the relationship between interest rate and exchange rate policies from the perspective of Australia and New Zealand country. We use monthly data for the period from January 1980 to July 2013. This provides sufficient data set for the empirical analysis. The results of Granger causality test evidence bidirectional relationship between interest rates and exchange rates. The results show that there is substantial lead lag relationship of interest rates to exchange rates. We found the same relationship of the exchange rate to the interest rate. These results are useful to investors and policy makers. In the point of view of investors, they can use this information history of interest rates and exchange rates to predict the movement of stock returns. Similarly , policy makers can stabilize the volatility of the stock market by adopting appropriate policies towards interest rate and the exchange rate for time to time .


The theoretical relationship between the interest rate and exchange rate policies has been a debatable issue among the economists. An increase in interest rate is necessary to stabilize the exchange rate depreciation and to curb the inflationary pressure according to Mundell-Fleming model. Therefore it helps to avoid many adverse economic consequences. There have some reasons why the high interest rate policy is considered important. First, it provides information to the market about the determination of the authorities did not allow sharp exchange rate movements as the market anticipates economic conditions and thereby reduce the range and prevent the vicious cycle of inflation and exchange rate depreciation. Second, it raises the attractiveness of financial assets in the state as a result of capital inflows occur and thus limit the depreciation of the exchange rate. Third, it not only reduces the level of aggregate domestic demand but also improve the balance of payments by reducing the level of imports. The critics argue that the high interest rates endanger the ability of local firms and banks to...

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