How does the world interest rate affect the real exchange rate?

Abstract

This paper develops a two goods overlapping generations model (OLG) of a semi-small open economy. Due to the OLG structure, the world interest rate and the domestic rate of time preference need not to be equal. Consequently, this setting represents the minimal real framework to study the effects of a world interest rate shock on the real exchange rate (RER).We show that both medium and long-run effects of a positive interest rate shock depend on the net financial position of the domestic country vis-ý-vis the rest of the world. The path of the RER is non monotonic (undershooting) in the case of a creditor country, while the RER simply appreciates in a debtor country.