An investigation of the causal relations between exchange rates and interest rate differentials using wavelets

- We study time scale relations between exchange rates and interest rate differentials.
- Causality test is used with wavelet filtered data to study the time varying relations.
- Impulse response functions present signs of the time varying relations.
- We find a strong causal relation in the long run.
- We also find a negative and positive relation in the short and long-run respectively.

This paper uses wavelet analysis to investigate causality between the spot exchange rate and the nominal interest rate differential for seven country pairs, which includes Sweden. Impulse response functions are also utilized to examine the signs of how one of these variables affects the other over time. One key empirical finding from the causality tests is that there is strengthening evidence of the nominal interest rate differential Granger causing the exchange rate as the wavelet time scale increases. When considering impulse responses on how the interest rate differential affects the exchange rate, there appears to be some evidence of more negative relationships at the shorter time scales (i.e. an increase in the Swedish interest rate compared to that of another country is associated with a lower Swedish krona price of the other country's currency) and more positive relationships at the longer time scales.