Co-Movements between Foreign and Domestic Interest Rates in a Fixed Exchange Rate Regime : The Case of the ECCU and the US

Economic theory posits that in a fixed exchange rate regime with unrestricted capital flows, domestic interest rates must track closely those of the country to which the currency is pegged. This paper empirically tests this theory by investigating the sensitivity of interest rates in the Eastern Caribbean Currency Union (ECCU) to changes in the US rates. The empirical results show long-run convergence between the two rates, indicating that interest rate parity holds for all countries in the ECCU. In the short-run, changes in the Fed funds rate have an almost immediate impact on lending rates and T-bill rates in the ECCU. The paper extends the empirical literature on the transmission of foreign interest rate changes and monetary policy independence in small open economies with fixed exchange rates