Exchange risk and the supply-side effects of real interest rate changes

Abstract

This paper studies the supply-side effects of real interest rate changes in a small open economy. Exchange risk premia in the foreign exchange markets allow domestic monetary conditions to have an impact on domestic real interest rates, driving them apart from those of the rest of the world. Under these circumstances, a reduction of domestic real rates relative to foreign rates brings significant benefits in terms of increased real output and employment and an improvement in the current account. Monetary policy is non-neutral, and the capital outflow induced by lower domestic real rates actually has a beneficial impact by improving the country's international credit position. The relationship between real interest rates and inflation is ambiguous, but for certain parameter values there may be a negative relationship, and hence an empirical long-run trade-off between inflation and unemployment (a long-run Phillips curve).