Study On The Linkage Relations Between RMB Interest Rate And Exchange Rate

The relationship between interest rate and exchange rate has been the focus issue in international finance research. Interest rate and exchange rate play the role of main operating indicators respectively in the currency market and foreign exchange market, and both of the two rates are vital tool of country monetary policy. For decades, China's interest and exchange rates have limited degree of market, and they are lacking in contact and interaction. However, with the full liberalization of the financial industry and promoting interest and exchange rates market reforms in China, researches are deservedly focused on the relationship between the RMB interest rate and exchange rate. In this paper, both theoretical and empirical study would be applied to the issue research.In the theoretical part, this paper is written to begin with theories about the relationship between interest rate and exchange rate. Firstly, this paper makes a review of the historical process of Interest Market and exchange rate system reforms, and analyzes the positive effects and shortcomings of reforms; secondly, this paper gives a detailed discussion about mutual transmission channels and mechanisms between interest and exchange rates under normal conditions. Ultimately, this paper offers a specific analysis of different transmission effects under different exchange rate systems.In the empirical chapter, based on theoretical research above, this paper makes empirical study on the relationship between the RMB interest rate and exchange rate. Sample interval is determined from the July 2005 to August 2009; variables include RMB inter-bank lending rates to 7 days, the U.S. federal funds rate and nominal exchange rate of RMB against the U.S. dollar. As for the empirical methods, this paper makes comprehensive use of ADF test, VAR model, co-integration test, Granger causality test, impulse response and variance decomposition measurement methods to construct quantitative model in the three variables, aiming at testing the strength and sustainability of the interaction between nominal interest rate and nominal exchange rate of RMB, and reach the conclusion that though the linkage relations between China's interest rate and exchange rate within the range is not obvious, co-integrating relations exists between the three variables from a long perspective. Finally, according to empirical results and examine the causes, this paper proposes recommendations and concrete measures to strengthen China's interest rate policy and exchange rate policy coordination, these measures involve China's interest and exchange rates regimes and capital account.