The Empirical Study On Factors Influencing Connected Effect Between Interest Rate And Exchange Rate

The interest rate parity theory describes the relation between interest rate, spot rate and forward rate. It helps predict forward rate. The market has to be a free market in which capital flows freely and traders can buy and sell with no cost, thus the theory is established. But, in China, there is capital control by the government and the RMB interest rate and exchange rate are not market-based, the theory does not apply to actual economic changes. Because of this, many scholars try to improve the interest rate parity model to increase its explanatory power for some economic phenomena. The strength of co-movement between interest rate and exchange rate may affect the effective combination of monetary policy and exchange rate policy, which helps realize the internal and external equilibrium of economy and effectively carry forward the financial market opening. Now, there are an amount of theoretical discussion and empirical tests about the interest rate parity theory and the connected effect between interest rate and exchange rate. According to the special relation between exchange rate and interest rate in China, some also provides adjusted interest rate parity model by introducing transaction cost and regime friction coefficient, which still cannot be measured concretely. By summarizing previous researches, we can find most of them support that the adjusted interest rate parity model can better reflect the connected effect between interest rate and exchange rate. Due to the low marketization degree of interest rate and exchange rate in China, the model remains to be perfected.This paper analyzes the empirical findings of interest rate parity model in literatures domestic and overseas and the adjusted model provided by scholars inland. Combining with the special transmission between interest rate and exchange rate in China, it aims to find out the influencing factors to be considered into the interest rate parity theory model. This paper starts the research of interest rate parity in four parts. Firstly, the literature reviews. In this part, it classifies the literatures about interest rate parity according to contents and makes conclusion on this basis. The second part is about theory and actuality. In this part, it describes the necessary theory of interest rate and exchange rate and the transmission mechanism between them. The third part describes the influencing factors. Combining the transmission mechanism with the current situation in China, it finds out the factors influencing the applicability of interest rate parity in China, and raises the theoretical assumptions for the empirical test of economic opening and financial development. The third part is about the empirical test which examines the influencing factors in second part. The last part includes the conclusion of all contents and corresponding suggestions.This paper uses EVTEWS6.0to do the empirical test. The data period crosses from the first quarter of2002to the third quarter of2013. The empirical research includes three parts, gradually deepened one by one. First of all, it starts from the co-movement theory of interest rate and exchange rate and analyzes the relation between interest rate and exchange rate in China and the US. Then it figures out the deviation value between theoretical value and actual value of forward rate and makes descriptive statistics to judge different trends of the deviation value under different period. Last, it divides the actual value by theoretical value to get the deviation degree, and minus one to obtain the deviation ratio. The absolute deviation ratio is the dependent variable, and the capital account openness and financial development level are independent variables. The multivariable regression of three variables can give the result of how the two independent variables act on the dependent variable. The empirical findings indicate that interest rate parity does not apply to China due to the low economic openness and financial development level, and there is usually a deviation between actual forward rate and equilibrium value. The increase of capital account openness and financial development level helps reduce the deviation ratio, which also means that the interest rate parity can better apply to China as the forward rate’s actual value is closer to its theoretical value. Hence, we can draw the conclusion that the interest rate parity does not apply to China. In order to make the interest rate parity come into exist in China, the capital account openness and financial development level should be improved. At the same time, the marketization of interest rate and exchange rate also requires being accelerated. The capital account openness is an indicator of economy openness and the financial development level is related with economic growth. Combining this with the conclusion, we can know that the increase of economy openness and growth helps provide a better financial environment and strengthen the co-movement between interest rate and exchange rate. The hypothesis of factors influencing interest rate parity is verified. It is accord with the hypothesis of interest rate parity theory.