The long-run interrelationship between exchange rate and interest rate: the case of Mexico

Purpose The purpose of this paper is to analyse the long-term nature of the interrelationship between interest rate and exchange rate. Design/methodology/approach By employing Mexican data, the authors estimate a non-linear autoregressive distributed lags (NARDL) model to investigate the nature of the changes and the interaction between interest rate and exchange rate in response to monetary authorities' actions. Findings The results show that, contrary to simplistic predictions, the real exchange rate causes the real interest rate in an asymmetric way. The bounds testing approach of the NARDL models suggests the presence of co-integration among the variables and the exchange rate variations appear to have significant long-run effects on the interest rate. Most importantly, these effects are asymmetric and positive variations in the exchange rate have a lower impact on the interest rate. It is also interesting to report that the reverse is not true: the interest rate in the long-run exerts no statistical significant impact on the exchange rate. Originality/value Under inflation targeting and flexible exchange rate regime, despite central banks pursue the control of short-term interest rate, in the long-run one could observe that it is the exchange rate that influences the interest rate, and that this reverse causality is stronger in emerging economies. This paper contributes by analysing the asymmetric relationship between the variables.