Causal relation between interest and exchange rates in the Asian currency crisis

Abstract

This paper studies the causal relationship between interest rates and exchange rates in Indonesia, Korea, Malaysia and Thailand during the period bordering the 1997 Asian currency crisis to investigate the appropriateness of tight monetary policy in stabilizing exchange rates. We employ VAR models consisting of spot rates, forward rates and interest rate differentials to study the causal relations. In particular, we test for long-run causality as well as short-run causality by taking into account non-stationarity of the involved variables and the cointegrating relations among them. The test results show that except for some subsamples for Malaysia there is no evidence that interest rate differentials caused spot exchange rates at all horizons. Considering the ineffectiveness of high interest rates in stabilizing exchange rates and the high economic cost associated with keeping high interest rates for an extended time period, one may rightfully question the appropriateness of tight monetary policy during the Asian currency crisis.