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Real exchange rates and real interest rate differentials: A present value interpretation

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  • Hoffmann, Mathias
  • MacDonald, Ronald

Abstract

Although the real exchange rate-real interest rate (RERI) relationship is central to most open economy macroeconomic models, empirical support for the relationship is generally found to be rather weak. In this paper we re-investigate the RERI relationship using bilateral US real exchange rate data spanning the period 1978-2007. Instead of testing one particular model, we build on Campbell and Shiller [1987. Cointegration tests of present-value models. Journal of Political Economy 95, 1062-1088] to propose a metric of the economic significance of the relationship. Our empirical results provide robust evidence that the RERI link is economically significant and that the real interest rate differential is a reasonable approximation of the expected rate of depreciation over longer horizons.

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Bibliographic Info

Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 53 (2009)
Issue (Month): 8 (November)
Pages: 952-970

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Handle: RePEc:eee:eecrev:v:53:y:2009:i:8:p:952-970

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Web page: http://www.elsevier.com/locate/eer

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Keywords: Real exchange rates Real interest rates Present-value model;

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References

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  1. Sbordone, A.M., 1998. "Prices and Unit Labor Costs: a New Test of Price Stickiness," Papers 653, Stockholm - International Economic Studies.
  2. Campbell, John & Perron, Pierre, 1991. "Pitfalls and Opportunities: What Macroeconomists Should Know about Unit Roots," Scholarly Articles 3374863, Harvard University Department of Economics.
  3. Edison, Hali J. & Pauls, B. Dianne, 1993. "A re-assessment of the relationship between real exchange rates and real interest rates: 1974-1990," Journal of Monetary Economics, Elsevier, vol. 31(2), pages 165-187, April.
  4. Newey, Whitney K & West, Kenneth D, 1987. "A Simple, Positive Semi-definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica, Econometric Society, vol. 55(3), pages 703-08, May.
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Cited by:
  1. Li, Kui-Wai & Wong, Douglas K T, 2011. "The Exchange Rate and Interest Rate Differential Relationship: Evidence from Two Financial Crises," MPRA Paper 35297, University Library of Munich, Germany.

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