The Relationship between Exchange Rates and Interest Rate Differentials: A Wavelet Approach

Abstract

This paper uses wavelet analysis to investigate the relationship between the spot exchange rate and interest rate differential for seven pairs of countries, with a small country, Sweden, included in each case. The key empirical results show that there tends to be a negative relationship between the spot exchange rate (domestic-currency price of foreign currency) and nominal interest rate differential (approximately the domestic interest rate minus the foreign interest rate) at the shortest timescales, while a positive relationship is more frequently found at the longest timescales. This indicates that among models of exchange rate determination using the asset approach, the sticky-price models are supported in the short run and flexible-price models in the long run. © 2012 Blackwell Publishing Ltd.