Is there a trade-off between exchange rate risk and interest rate risk?

Series: Working Papers. 9529.

Author: Juan Ayuso Huertas.

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Is there a trade-off between exchange rate risk and interest rate risk? (2 MB)

Abstract

This paper presents a simple macroeconomic model based on Svensson (1994). The model incorporates innovations that provide for a simultaneous explanation of the three basic findings in the empirical literature concerning the effects of the EMS on the levels of exchange rate risk and interest rate risk: the reduction in exchange rate variability when the degree of rigidity in the exchange rate commitment increases; the indetermination in the sign of the behaviour of exchange rate risk when this commitment eases; and, lastly, the possibility that, in some cases, a trade-off exists between exchange rate risk and interest rate risk, and that, in other cases, both move in the same direction.