A small open economy’s view on interest rate differential’s relation to the nominal exchange rate

Abstract: The characteristics of interest rate differentials’ relationships with the change in nominal exchange rates are here investigated from the small open economy Sweden’s pointof view. We assume rational expectations and risk neutrality. However, these are solelysufficient but not necessary conditions. The only necessary condition is that the deviationsfrom rational expectations and risk neutrality are uncorrelated with the interestrate differential (Chinn and Meredith 2004, p. 412). We find no evidence for the interestrate differentials to be unbiased predictors of the percentage change in nominalexchange rates. With 3- and 6-month maturity interest rates, the signs are positivealthough not statistically different from zero.