A semi-parametric study on dynamic linkages among international real interest rates

Linkages between real interest rates among countries have been extensively investigated in the literature as it has important policy implications for the monetary authorities in the policy making process. Even in a perfectly efficient international interest rate market, equal real interest rates are not expected because of the existence of transaction costs and hence nonlinear approaches that take transactions costs into account are necessary to evaluate the relationship between real interest rates. A semi-parametric, generalized additive vector autoregressive models were applied to a consideration of real interest rate linkages among the US, the UK, Japan, Switzerland and the Eurozone. Through nonlinearity tests, we find strong evidence that nonlinearities substantially characterize real interest rate linkages. Generalized impulse response functions are utilized to investigate the dynamics of real interest rates after shocks of different sizes, directions, and histories. All marginal effects from four models backed by different economic theories and generalized impulse responses from vector error correction models support the real interest rate parity hypothesis which indicates a high degree of integration in capital markets. The results provide evidence that the conventional tests which rely on linearity assumptions may lead to misleading inferences and local monetary policy makers can only affect the real interest rates when the international financial markets are close to the equilibrium; the efforts of the policy makers may be offset by the arbitrage behavior when this condition is not satisfied.