A Wavelet Approach For Analysing The Relationship Between Exchange Rate And Interest Rate Differential
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Date
2017-02
Authors
Dhamotharan, Lalitha
Journal Title
Journal ISSN
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Publisher
Universiti Sains Malaysia
Abstract
The relationship between exchange rate and interest rate differential remains one of the most debated areas in macroeconomics. The relationship is often derived from the purchasing price parity and uncovered interest rate parity theories. An evaluation of the empirical research reveals contradictory findings with inconclusive results. First, most of the empirical studies posit a linear relationship between the variables. However, nonlinearities may exist due to market frictions. Second, most of such studies utilise the conventional econometric approach that is limited by its one-dimensional analysis. Hence, a consolidated approach with the objective of reducing the research gap is proposed that include investigating the dynamic relationship for developed and emerging economies via vector autoregressive modelling and causality test that accounts for linear and nonlinear characteristics within the short and long horizons. Further, multi-dimensional wavelet transform were utilised to tease out these effects and reconcile the objectives. Wavelet analysis is able to decipher information of a series on a time-frequency domain without being limited by the structure of the data. This ideal characteristic allows the utilization of wavelet decompositions from discrete wavelet transform and maximal overlap discrete wavelet transform to be analysed using bivariate linear and nonlinear Granger causality test to uncover the relationship between exchange rates and interest rates differentials for thirteen developed nations (Austria, Canada, France, Germany, Greece, Italy, Japan, Netherlands, Singapore, South Korea, Sweden, Switzerland, United Kingdom) and five emerging markets (Chile, India, Philippines, South Africa and Thailand) during the span of January 1990 to December 2013.
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Keywords
A wavelet approach for analysing the relationship , exchange rate and interest rate