Empirical Research On Correlation Between RMB Interest Rate And Exchange Rate

Interest rate is an important indicator of a country’s money market; also it is a country’s most important monetary policy tool. While the exchange rate is the most important indicator in foreign exchange market, it affects a country’s international balance of payment. These two indicators are under the control of monetary policy of the People’s Bank of China, play an important role in promoting the internal and external economy balance of our country. In the mean time the both will influence each other through many ways in the real economy. Keynes, Mundell, Fleming and many other economists have already building models such as interest rate parity or Mundell-Fleming model to analyze the relationship between interest rate and exchange rate. Under the background of global macroeconomic synchronization, now China’s economy is continuing to integrate into the world economic system, the mortgage crisis in the subprime occurred in 2007 causes a recession in many countries, international trade protectionist forces strongly accuse of China’s large current account surplus, and current account surplus is continuing to lead to a sustained increase in the scale of China’s foreign exchange reserves, the stress of the RMB exchange rate appreciation always exists, China’s monetary policy independence is seriously challenged; also the RMB appreciation has attracted a lot of international hot money to make risk-free arbitrage in China, which also leads China’s capital account surpluses, therefore China faces its double surplus balance of payments. Under the global macroeconomic situation, we can see that our country is at a critical moment of interest rate market-oriented reform and exchange rate market-oriented reform, now researching the correlation between interest rate and the exchange rate will make sense in guiding the coordination between interest rate policy and exchange rate policy and the implementing of interest rate market-oriented reform and exchange rate market-oriented reform.The paper first describes the classical theory of linkage between interest rate and exchange rate such as Interest Rate Parity Theory, Mundell-Fleming Model and Dornbusch Overshooting Model. Secondly, the paper analyses interest rate and exchange rate transmission channel through the current account, the capital account, asset conversion and so on. Again, the paper describes China’s interest rate policy and exchange rate policy evolvement process in chronological order. Then, with the key point of RMB exchange rate market reform in July 2005, the paper selects the 90 monthly data from July 2005 to December 2012. The variables include real effective exchange rate of RMB,7 days interbank market effective weighted average interest rate, the broad money supply M2, foreign exchange reserves and the China-US actual interest rates spreads. The paper studies the correlation between interest rates and exchange rates under the situation with only interest rates, exchange rates and the situation with the whole five variables through the integrated use of ADF unit root test, EG two-step cointegration test, vector autoregression model(VAR), the impulse response measurement function (IRF) and variance decomposition. Then the paper analyses the results of econometric analysis. Finally, according to the results of previous analysis, the paper proposes policies to improve the linkage between interest rates and exchange rates in our country and make the finally summary.