Foreign interest rate shocks and exchange rate regimes in East Asia

Abstract

Using a theoretical dynamic stochastic general equilibrium model and an empirical panel vector autoregression, we assess the transmission of foreign real interest rate shocks on the volatility of various key macroeconomic variables in nine small open economies in East Asia taking into account the role of exchange rate regimes. Both the theoretical and empirical findings confirm the hypothesis that flexible exchange rate may work as a shock absorber when the economy is hit by foreign real interest rate shocks. The findings suggest a clear trade-off between the volatility of real exchange rate and real output to foreign interest rate shocks, both the US and G7 real interest rates, where the responses of real output are mitigated in countries that have more flexible exchange rate regime.

Keywords:

• exchange rate regime
• foreign interest rate shocks
• East Asia
• panel VAR

JEL Classification:

• F41
• E30
• F31

Acknowledgements

We are grateful to two anonymous referees and to participants at the FEG-ACAES Conference for their very helpful comments and suggestions. Yang Zhang gratefully acknowledges financial support from University of Macau, Project Reference Number MYRG083(Y1-L1)-FBA11-ZY. Wai-Mun Chia also thanks the AcRF Tier 1 (RG51/09) for financial support. Any errors are the responsibility of the authors.

Notes

¹ Similarly, Friedman (1953) and Mundell (1961) hypothesize the role of flexible exchange rates as a shock absorber.

² For example, Singapore and Korea are much more developed compared of the rest of the sample.

³ For example, even though India is a developing country, its economic size is much larger than the rest of the sample.

⁴ We also change the ordering of the endogenous variables to see whether the impulse response functions are affected by the ordering of the variables. We confirm that there is no significant difference in the responses.