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The real exchange rate and real interest differentials: the role of nonlinearities

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  • Nelson C. Mark

    (University of Notre Dame and NBER, USA)

  • Young-Kyu Moh

    (Tulane University, USA)

Abstract

Recent empirical work has shown the importance of nonlinear adjustment in the dynamics of real exchange rates and real interest differentials. This work suggests that the tenuous empirical linkage between the real exchange rate and the real interest differential might be strengthened by explicitly accounting for these nonlinearities. We pursue this strategy by pricing the real exchange rate by real interest parity. The resulting first-order stochastic difference equation gives the real exchange rate as the expected present value of future real interest differentials which we compute numerically for three candidate nonlinear processes. Regressions of the log real US dollar prices of the Canadian dollar, deutschemark, yen and pound on the fundamental values implied by these nonlinear models are used to evaluate the linkage. The evidence for linkage is stronger when these present values are computed over shorter horizons than for longer horizons. Copyright © 2005 John Wiley & Sons, Ltd.

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Bibliographic Info

Article provided by John Wiley & Sons, Ltd. in its journal International Journal of Finance & Economics.

Volume (Year): 10 (2005)
Issue (Month): 4 ()
Pages: 323-335

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Handle: RePEc:ijf:ijfiec:v:10:y:2005:i:4:p:323-335

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References

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Cited by:
  1. Juan Carlos Cuestas & Barry Harrison, 2009. "Further evidence on the Real Interest Rate Parity hypothesis in Central and Eastern European Countries: unit roots and nonlinearities," Working Papers 2009/1, Nottingham Trent University, Nottingham Business School, Economics Division.
  2. Liu, Yan & Chang, Hsu-Ling & Su, Chi-Wei, 2013. "Do real interest rates converge across East Asian countries based on China?," Economic Modelling, Elsevier, vol. 31(C), pages 467-473.
  3. Su, Chi-Wei & Chang, Hsu-Ling & Liu, Lin, 2012. "Real interest rate parity with Flexible Fourier stationary test for Central and Eastern European countries," Economic Modelling, Elsevier, vol. 29(6), pages 2719-2723.
  4. Marcello Pericoli & Marco Taboga, 2009. "Bond risk premia, macroeconomic fundamentals and the exchange rate," Temi di discussione (Economic working papers) 699, Bank of Italy, Economic Research and International Relations Area.
  5. Liu, Lin & Chang, Hsu-Ling & Su, Chi-Wei & Jiang, Chun, 2013. "Real interest rate parity in East Asian countries based on China with flexible Fourier stationary test," Japan and the World Economy, Elsevier, vol. 25, pages 52-58.

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