Investigating the co‐movement between exchange rates and interest rates in the bi‐variate form: Evidence from Turkey

Abstract

The exchange rate is considered one of the most important economic factors that monetary authorities seek to control in proportion to its current and its future economic activities. In this study, we investigate the interrelationship between the interest rate and exchange rate at different time horizons (overnight, 6 months and up to 1 year) in Turkey using wavelet analysis, mainly continuous wavelet, cross wavelet, and wavelet coherence, during the period from 2005 to 2019. The results indicate that the relationship in the long‐run and short‐run between exchange rate and interest rate is generally positive and this confirms the purchasing power parity theory and Keynesian approach theoretical predictions on the relationship between exchange rate and interest rate—the negative relationship in the short term is consistent with sticky price models. In terms of the causality, although there is no specified pattern for this relationship, it is evident that the behavior of the lead‐lag relationship between the variables, in the long run, is different from the short run, the exchange rate dominates in the long run. In contrast, in the short‐run, there is a bidirectional causality that varies substantially over time and virtually changes from day to day in the short‐run.