Relationship between exchange rates and interest rates: Case of Albania

Abstract

This study aims to explain the impact that interest rates have on exchange rate fluctuations. Fluctuations in exchanges can bring large profits, but can also can cause severe loses. Theory suggests that if interest rates on domestic currency increase, then this currency will appreciate against foreign currency. However, this is not always the case, as literature on this topic suggests.To examine this relationship regression analysis is used. Data used in this analysis corresponds to the period from January 2002 until December 2014. This relationship is studied by constructing two models accounting for exchange rate of USD/ALL and EUR/ALL, separately, and their relationship with interest rates. USD to ALL exchange rates and EUR to ALL are the dependent variables in each model, while interest rates on ALL deposits are used as the independent variable for both models.The results show that in the case of Albania, an increase in interest rates of deposits in ALL, caused the exchange rate of ALL/USD to increase, with USD becoming more expensive. While in the case of EUR/ALL exchange rate, it was found that when interest rate in ALL deposits increase, ALL was appreciating against Euro. Therefore, Lek was becoming more expensive.