The exchange rate and the term structure of interest rates in Mexico

Abstract

Mexico adopted a floating exchange rate regime in December 1994. The Bank of Mexico's monetary policy gives attention to maintain “orderly conditions in foreign exchange markets.” The Bank of Mexico relies primarily on the control of the overnight interest rate in conducting its monetary policy. The question arises whether this extremely short-term interest rate is the relevant instrument to achieve exchange rate objectives. Theory suggests that the relationship between the exchange rate and the term structure of interest rates can be complicated and counterintuitive when investors are risk averse. In this paper, we pursue an empirical investigation on the effect of the term structure of interest rates on the exchange rate for Mexico. This information could be useful to understand and manage the operation of the Mexican floating exchange rate regime.