Foreign interest rate shocks and exchange rate regimes of small open economies : experience from Hong Kong and Singapore

Abstract

Recent decades have witnessed a steady decline in the real interest rates associated with US Treasury securities, especially after 2008 US subprime crisis. Since the spillover effect of developed or large economies on the small open economies is largely through trade and financial linkages, any shocks from other countries could have a significant effect on the domestic economy. This study aims to address the question of whether exchange rate regimes play a role in influencing the macroeconomic performances of comparable small open economies in response to foreign real interest rate shocks. Particularly, experiences from Hong Kong and Singapore are studied from both theoretical and empirical approaches because they are comparable economies with different exchange rate regimes from the period of 1984 to 2010. Theoretical framework was derived based on Mundell-Fleming Model and AD-AS Model, followed by applying Vector Error Correction Model (VECM) to estimate and interpret empirical results in Hong Kong and Singapore. Unit root test and Cointegration test were conducted to select the model before the identification of reduced VECM and structural form. Impulse Response Functions (IRF) were computed and Forecast Error Variance Decompositions (FEVD) were provided as supplementary evidence. This study demonstrates that Hong Kong and Singapore will have different macroeconomic performances under foreign real interest rate shocks, since exchange rate regimes do play a role in the transmission mechanism of foreign real exchange rate shocks. Therefore, our study provides implications for small open economies regarding their policy choices of exchange rate regimes. Moreover, our study could also help explain the increasing popularity of floating exchange rate regimes in the recent decades.