Does Interest Rate Still Matter in Determining Exchange Rate?

Abstract

The interest rate plays an important role in determining the exchange rate in various economic theories. However, this has been challenged both conceptually and practically. The rapid development of global financial linkages makes many attractive non-interest-bearing investments available, which dwarf the profit opportunity from interest-bearing assets. The sensitivity of the exchange rate fluctuations and institutional factors also cast doubt on the role of the interest rate in determining the exchange rate. This research used nine Asian countries, five of which are ASEAN members (Thailand, Indonesia, Malaysia, Singapore, and the Philippines), the others being South Korea, Japan, India, and China. The sample period varied between 1994 and 2015. The results from the Pool Mean Group method show that the real effective real interest rate has a significant long-run negative association with the exchange rate. This implies that the interest rate does matter in determining the exchange rate.