BS Review - July 2006

Abstract

Exchange Rate and Interest Differential Nexus in the Philippines: A Vector Error Correction Approach
Ms. Eloisa Glindro and Ms. Irene Estigoy

The study is an attempt to examine the exchange rate-interest rate differential nexus in the Philippines using the Vector Error Correction (VEC) model. In view of the inherent simultaneity between exchange rate and interest rate, the VEC has the novelty of conveniently dispensing with the strong a priori distinction between exogenous and endogenous variables required in the usual structural models.

The selection of relevant foreign interest rates (short-term and long-term) considered in the construction of interest rate differentials included in the VEC model was made on the basis of these cointegrating relationship with Philippine Treasury rates.

Results of the preliminary tests undertaken using the VEC model indicate that an expectation of a depreciation leads to higher interest rate differentials. An interesting result is the apparent substitution between assets of different maturities whenever there is a shock on the long-term interest rate differential. This seems to favor the contention that the uncovered interest rate parity condition is a long-term relationship.

With regard to the response of the exchange rate to a shock on interest rate differential, a shock on the short-term interest gap results in a very negligible depreciation while a shock on the long-term interest differential leads to a much sharper appreciation. The implication is that an interest defense of the exchange rate is effective only if it is credible to the extent that it is reflected in the long-term interest rates. This is further supported by the small magnitude of the impact of the interest differential on exchange rate depreciation

Views from Washington: Multilateral Surveillance by the Fund
- Ma. Cyd N. Tuaño-Amador

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