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Management & Engineering 06 (2012) 1838-5745
Contents lists available at SEI
Management & Engineering
Journal Homepage: www.seiofbluemountain.com
Empirical Research on Interest Rate and Exchange Rate in China
Junjiang LI, Qiao DONG
School of Management Science and Engineering, Central University of Finance and Economics, Beijing 100081,
P.R.China
KEYWORDS
ABSTRACT
Interest rate,
Exchange rate,
Coordination
Though the relationship between interest rate and exchange rate is focus of many
macroeconomic models, the empirical research often gets contrary conclusions. Because of
the role of interest rate and exchange rate in promoting economic growth, it is necessary to
learn the relationship between the two economic variables. In the article, we use Granger
causality test to study the exchange rate--interest rate transmission mechanism, and conclude
that the transmission mechanism do not work well after the exchange reform in China.
Eventually, we bring forth some suggestions to cohere interest rate policy with exchange rate
policy.
© ST. PLUM-BLOSSOM PRESS PTY LTD
1 Literature Review and Summary
From interest rate parity to sticky price monetary approach (Dornbusch, 1976), interest rate and exchange rate is always the focus of
macroeconomic models. Though most macroeconomic models agree that exchange rate is affected by basic economic variables
including interest rate, the empirical research often get different even contrary conclusions.
Mathias Hoffmann (2009) stated that scholars hold ample evidence to support the correlation between interest rate and exchange rate.
Empirical analysis was adopted by Ronald MacDonald and Jun Nagayasu (2000) to analyze it under the floating exchange rate. The
result shows that real interest rate spread and real exchange rate have a long-run equilibrium relationship. Hali J. Edison and B.
Dianne Pauls (1993) used Cointegration Analysis and error correction model to test the relationship between real interest rate spread
and real exchange rate. The dynamic model shows that they have long-run equilibrium.
Opponents also have sufficient evidence to prove the irrelevancy. Calvo and Reinbar (2002) study the correlation in developing
countries and conclude that the relationship is vague in these countries. Mishkin (1984) was suspicious of the correlation.
From the research above, the difference of conclusions depends on the data and methods. In this article, we use ADF test and
cointegration analysis to study the relevance after exchange reform in China.
2 Theoretical Analyses
According to Fisher effect equation, nominal interest rate equals to the sum of real interest rate and expected inflation rate:

Corresponding author：
E-mail: [email protected]
English edition copyright © ST. PLUM-BLOSSOM PRESS PTY LTD
DOI: 10. 5503/J. ME. 2012. 06. 013
69
iit  rit  Eitpi ( t  1), i  1,2,..., N , t  1,2,...T
iit is the nominal interest rate of ith country in time t, rit is the real interest rate of ith
expected inflation rate of time (t+1) of ith country in time t.
(1)
country in time t,
Eitpi ( t  1) is the
Equation (2) is UIP:
Eiti (t  1)  iit  iit 
(2)
A parity condition states that the difference in interest rates between two countries is equal to the expected change in exchange rates
between the countries’ currencies. If this parity does not exist, there is an opportunity to make a profit. In the equation, iit  is
foreign country's long term interest rate.
Real exchange rate shows as follow:
it  pit  pit  eit
(3)
it is long term nominal interest rate; pit and
(3) into expectation form, we get equation (4):
pit  stand for domestic and foreign price, eit is real long term exchange rate. Change
Eiti ( t  1)  Eitei ( t  1)  Eitpi ( t  1)  Eitpi (t  1) 
Subtract Eiti (t  1) in both sides, the result is the following:
eit  Eitei (t  1)  (i  Eitpi (t  1))  (iit   Eitpi (t  1))
Combine (1) and (2):
eit  Eitei (t  1)  rit  rit 
(4)
(5)
(6)
Equation (6) shows current real exchange rate can be calculated by expected real exchange rate and the difference of real interest rate.
According to Meese and Rogoff (1998), Edison and Pauls(1993), expected real exchange rate has no long-term relationship with
current real exchange rate, so we suppose it is a constant: Eitei (t  1)  i .
So we have
eit  i   1rit   2 rit 
(7)
3 Empirical Analyses
3.1 Data acquisition and data processing
As China made an exchange reform on July 21 st, 2005, we take data after July 2005. So we use the data from August 2005 to July
2010. We get the real effective exchange rate from the website of BIS. Real effective exchange rate (ER) is calculated as geometric
weighted averages of bilateral exchange rates. US long-term interest rate (USIR) is got from OECD database. Then we adopt
interbank offered rate (1 week) and corporate goods price indices to figure out real interest rate (CNIR), both from the website of the
people's bank of China. All above data are monthly.
3.2 Data analysis and conclusion
3.2.1 Stationarity analysis
To ensure the stationarity of results, firstly we should take stationarity analysis of sample data, using ADF one unit test.
Table 2
Variable
CNIR
USIR
ER
Difference order
t-Statistic
Prob.
0
-1.244945
0.6428
1
-4.833063
0.0007
0
-1.024034
0.7338
1
-4.582846
0.0008
0
1
-1.367419
-8.004461
0.5868
0.0000
CNIR, USIR and ER are all non-stationary series, but if they are differenced one time, they will become stationary.
That is to say CNIR~I (1), USER~I (1), and ER~I (1).
3.2.2 Cointegration analysis
To test whether there is long-term relationship between variables, we use Max-Eigen value cointegration analysis to test the time
series. The following indicates no cointegration at the 0.05 level, and the possibility of nonexistence of long-term relationship
between CNIR, USIR and ER goes up to 0.1477.
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No. of CE(s)
Eigen value
Statistic
Critical Value
Prob.**
None
0.403156
17.54741
21.13162
0.1477
At most 1
0.297214
11.99190
14.26460
0.1110
At most 2
0.027996
0.965431
3.841466
0.3258
Max-Eigen value test indicates no cointegration at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values
3.2.3 Granger causality test
Granger causality is a statistical concept of causality that is based on prediction. According to Granger causality, if a signal X1
"Granger-causes" (or "G-causes") a signal X2, then past values of X1 should contain information that helps predict X2 above and
beyond the information contained in past values of X2 alone. To make further efforts to test the relationship between the three
variables, we adopt Granger causality test, the result is following:
Null Hypothesis:
CNIR does not Granger Cause ER
Obs
F-Statistic
Probability
34
0.98889
0.38419
0.40319
0.67187
2.08662
0.14235
4.77470
0.01613
0.20093
0.81910
5.04504
0.01318
ER does not Granger Cause CNIR
USIR does not Granger Cause ER
34
ER does not Granger Cause USIR
USIR does not Granger Cause CNIR
34
CNIR does not Granger Cause USIR
There is no Granger causality between CNIR and ER, which means that the transmission mechanism between China's interest and
exchange rates don’t pass the test, at least, is not obvious with statistical significance. USIR does not Granger Cause ER, USIR does
not Granger Cause CNIR, which means the transmission mechanism between China and United States is vague, perhaps it is because
the control of interest and exchange rate in China, keeping both in a managed floating direction. What's more, ER and CNIR granger
cause USIR, which is quite different from the analysis of former scholars. During the financial crisis, China makes a great effort of 4
trillion expansive fiscal policies to help the world economy to get through the crisis smoothly, making China increase power of
influence.
4 Suggestions
4.1 Marketization of exchange rate
In order to raise the efficiency of our economy, we should let the exchange rate. The reform of exchange rate should be based on the
practical situation of our country and be advanced positively and steadily with complicated elements taken into consideration and a
scheme thoroughly established. People expect a brand new formation mechanism of foreign exchange to ensure that the Chinese
economy keeps healthy and comparatively rapid development. People are also expecting that the government of China can hold the
initiative right of reform all the while, and avoid the situation that the Chinese economy be cornered among crises due to submitting
to external pressures.
4.2 Marketization of interest rate
Interest rate marketization reflects the effect of resource allocation optimization. Interest rate marketization shall play a fundamental
role in coordination with market and resources, in order to optimize resource allocation. Interest rate is also a reference price for
many other products. The reform process shall respect the enterprises' decision-making powers, among which the principal pricing
right. Except for financial policy institutions, the majority of financial institutions operate under the standards setting up for common
enterprises. In addition, an important aspect reflecting enterprise' financial autonomy is their pricing right. Interest rate marketization
can by and large reflect the requirement of macro control. Macro control includes the currency policy of the central bank. There
should be a smooth and effective transmission mechanism to influence market prices as well as market pricing.
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4.3 Coordination of interest rate policy and exchange rate policy
The marketization of exchange rate and that of interest rate cannot be undertaken separately; otherwise it will lower the co-movement
of exchange rate and interest rate and the degree of marketization of the whole economy. So we suggest that with the marketization
of the exchange rate, the government should precede the interest reform at the same time, and utilize both the interest rate policy and
exchange rate policy to stabilize the whole economy. Only through such a method can China finish both of the two marketization
procedure.
References
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Management Research, February, 2010.
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Study Based on the VAR-GARCH Model [J]. Statistical Research, February 2005. (in Chinese)
[4]. Marcelo Sánchez. The link between interest rates and exchange rates, do contractionary depreciations make a difference? [J].
European Central Bank working paper series, November 2005.
[5]. Viktoria Hnatkovska, Amartya Lahiri, Carlos A. Vegh. Interest Rates and the Exchange Rate: A Non-Monotonic Tale [J].
March 2008.
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