Exchange rate and interest rate differential: A conundrum re-examined via wavelet analysis

This study explores modeling exchange rate by infusing conventional with unconventional techniques. To exemplify the practicality of wavelet analysis with an empirical application, the causal nexus between real exchange rate and real interest rate differential was examined in Singapore (vis-à-vis the US) via a novel approach known as the maximal overlap discrete wavelet transform during the period of 1990 to 2013. The key empirical finding from the causality test reveals the reinforcing evidence between the variables in the long-term. The time-scale decomposition of the series by wavelet analysis is vital when deciphering complex nonlinear economic models that otherwise remain equivocal when using conventional econometric methods.