The Riksbank and International Interest Rate Dynamics

Abstract

Based on the case of Sweden, this thesis studies the relationship between the nominal interest rate in a small open economy and the interest rates of the country's trading partners. Cross-country interest rate differentials affect domestic economic conditions through two channels; the exchange rate channel and via capital flows. This means that interest rate differentials can have both expansionary and contractionary effects, depending on the circumstances. Contrary to common theoretical monetary policy frameworks, which model international aspects only through its effect on domestic conditions, there are good arguments that interest rate differentials affect a central bank's considerations in a small open economy. This thesis presents empirical support suggesting a significant positive relationship between the Swedish Repo Rate and a trade-weighted foreign interest rate. The positive relationship is robust through different estimation techniques. Based on the empirical results, the thesis proposes a theoretical framework for modelling such a dependency structure using a DSGE model. The thesis concludes that international dynamics should be considered in macroeconomic models that analyze the interest rates of small open economies.