interest rate and exchange rate- economic concept

Question

Does UIP say that key interest rates have an impact on the exchange rate? Are maybe other economic concepts? Can somebody recommend me literature? On the Internet, I found that from the Mundell Fleming model, it follows that policy dumping imports would cause the exchange rate appreciation. I look at this model and I am confused. I cannot see the above-mentioned relationship

Answer 1

The so called uncovered interest rate parity is defined like this:

$$(1+i_{\\\$})={\frac {E_{t}(S_{{t+k}})}{S_{t}}}(1+i_{c})$$

or rearranged:

$${{S_{t}}}\frac {(1+i_{\\\$})}{(1+i_{c})} = E_{t}(S_{{t+k}})$$

If you think of EURUSD now (how many USD per EUR, say 1.2, if US interest rate is 10% and EUR 5% you get (for a year), the value of

$${1.2}*\frac {(1+0.1)}{(1+0.05)} = 1.25714286$$

In other words, you need more USD per EUR - the USD depreciated, EUR appreciated. That said, there exists a widely used strategy called the "carry trade". For the carry trade to work, this cannot be the case (higher interest currencies do not depreciate as much, on average). It is a successful strategy, but very risky because there is a tendency for this depreciation to actually happen - often rapidly during terms of crises. That is why there is the saying that with a carry trade you walk up the stairs (small steady returns) and go down the escalator (large sudden losses). If you wonder why this relationship makes sense, it is mainly due to differences in inflation rates. The image below is from FRED using FredApi in Julia.

Turkey has a higher interest than the US but still, the Lira depreciates steadily against the USD. The reason is higher inflation.

Empirically, FX is also more volatile than this relationship suggests.

There are numerous theories:

• parity conditions like covered and uncovered interest rate parity
• purchasing power parity (relative and absolute PPP): Frenkel (1978) shows this holds well for high inflation countries. Other studies show that it is usually strongly rejected in "normal" cases.Taylor & Taylor's paper provides excellent references.
• Real exchange rates
• Balassa Samuelson hypothesis
• Fisher hypothesis
• Balance of payments (BoP) which summarizes the demand and supply of currencies through international trade and capital flows (flow approach)
• stock approach: flexible and sticky price monetary models which combine capital markets, goods markets and money markets. Sticky price monetary models are also known as overshooting models.

Dornbusch (1976) started the sticky price models. Only difference to flexi price is that PPP (good market) does not hold in the short run. There are numerous extensions that all work well in the Monday morning quarterback sense (with the benefit of hindsight, you believe you can explain a lot).

There are also several so called FX puzzles:

• Meese Rogoff above
• FX disconnect puzzle; stating that nominal FX movements are virtually unrelated to economic fundamentals like CPI or RPI
• excess volatility puzzle; because the FX volatility exceeds that of the underlying economic fundamentals substantially
• forward premium puzzle (which makes carry trades possible)
• 1st PPP puzzle: lack of evidence for long run PPP
• 2nd PPP puzzle: related to excess vola puzzle

Engle and West (2005) show in the journal of political economy that exchange rates can be expressed as the expected discounted value (NPV) of observable and unobservable fundamentals (basic idea of a forward looking flexible price monetary model).

In general, neither of these models perform well or can be used for forecasting. Kenneth Rogoff and Richard Meese received an incredulous reaction to their now-famous paper showing that random-walk (RW) forecasts outperform economic models of exchange rates. Reactions were along the line of “You just cannot possibly have done it right” or "the results are obviously garbage". Turned out they were correct. Rogoff makes an interesting point in some later paper. If money supplies are hard to predict, then one should not blame the models if exchange rates are hard to predict. It is unforeseen news that matters. However, as Rogoff further stated, their finding was even more extreme. They tested predicting the exchange rate in one year, given the information about what money supplies, interest rates, and outputs are going to be in one year. However, even in this case, no economic model beat(s) the RW.

Unless inflation is substantial, it will never be clear what the impact will be.

Answer 2

Does UIP say that key interest rates have an impact on the exchange rate?

Yes under UIP exchange rate change should be equal to the relative difference in interest rates.

Are maybe other economic concepts? Can somebody recommend me literature?

Interest rates feature in virtually all models of exchange rates I can think of. You can have look at Copeland: Exchange Rates and International Finance for undergraduate treatment of many models.

On the Internet, I found that from the Mundell Fleming model, it follows that policy dumping imports would cause the exchange rate appreciation.

Do you mean dumping exports? Dumping imports does not make sense. If government pursues policy that dumps exports, i.e. makes exports cheaper than their production costs due to lets say subsidies, then that will indeed lead to currency appreciation, not just in Mundell-Fleming model but in broader set of models, because, generally speaking, in order for foreigners to import what home country is exporting they have to get home country's currency, thus increasing demand for home's currency in forex market which leads to currency appreciation.