Are Exchange Rates Becoming More Responsive to Monetary Policies?
As noted above, the UIP condition linking interest rate differentials and expected future exchange rates assumes open capital accounts and perfect substitutability of assets denominated in different currencies. Conversely, when capital accounts are closed and/or assets highly unsubstitutable, interest rate differentials are expected to have little or no direct impact on exchange rates. Accordingly, it is plausible that as financial globalization proceeds, currency values may become more responsive to interest rate differentials, thereby reinforcing the exchange-rate channel of monetary policy transmission (Mishkin, 2008). As noted above, such a trend could also help explain a greater responsiveness of domestic monetary policy to movements in foreign short rates.15 In practice, there is little support for the hypothesis that financial globalization has increased the responsiveness of exchange rates to monetary policy. Chart 11 presents correlations between short-term interest rate diffe
