Abstract
A simplified two-country macromodel is developed to analyze the relationship between the international linkage of interest rates and the exchange rate volatility. A fundamental trade-off exists between them in that the weaker the international linkage of capital, the more volatile the behavior of the foreign exchange rates. Depending on the degree of capital mobility, the foreign exchange rates may be so volatile that it is impossible for macroeconomic policy to have a systematic influence on the level of the foreign exchange rates, undermining the effectiveness of the macroeconomic policy.
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