The Impact of Foreign Interest Rates on the Economy: The Role of the Exchange Rate Regime

It is often argued that small economies are affected by conditions in large countries. This paper explores the connection between interest rates in major industrial countries and annual real output growth in other countries. The results show that high large-country interest rates have a contractionary effect on annual real GDP growth in the domestic economy, but that this effect is centered on countries with fixed exchange rates. The paper then examines the potential channels through which large-country interest rates affect small economies. The direct monetary policy channel is the most likely channel when compared with other possibilities, such as a general capital market effect or a trade effect.