Do Interest Rates Affect the Exchange Rate Under Capital controls? An event study of Iceland’s experience with capital controls

Abstract

We study Iceland’s experience with capital controls, in particular whether changes in the central bank’s policy rate affected the exchange rate under the capital control regime from 2009 to 2015.We find that both actual changes and unexpected changes in interest rates may have affected the exchange rate when the year 2009 is included in a sample that ends in August of 2015, but not when it is excluded. This early period was characterized by lax capital controls until November of 2009. It follows that, based on the experience of the moderate changes of interest rates observed in the data, changes in interest rates may affect the exchange rate when capital controls are not effectively enforced but will have a small, if any, effect when they are enforced. It should be noted that the results are based on the experience of moderate interest rate changes during this time period. Moreover, interest rates affect other variables, such as aggregate demand and the rate of wage inflation.