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PPP and the real exchange rate-real interest rate differential puzzle revisited: evidence from non-stationary panel data

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  • Georgios E. Chortareas
  • Rebecca L. Driver

Abstract

This paper examines the evidence for two of the relationships that underpin (explicitly or implicitly) much of international macroeconomics. The first is purchasing power parity (PPP), or the hypothesis that there exists a constant long-run equilibrium real exchange rate. The second establishes a relationship between real exchange rates and real interest rate differentials. The tests are conducted on a panel of 18 OECD economies using the United States as a numeraire for the post-Bretton Woods era. The results are obtained using new non-stationary panel estimation techniques, which significantly increase the power of the tests. All the tests suggest that there is little evidence supporting PPP when it is tested directly. This contrasts with earlier panel data studies, which tended to find that the real exchange rate was stationary. The results supporting a long-run relationship between real exchange rates and real interest rate differentials appear to be more positive. This again provides a contrast with earlier results, which tended to find no evidence of cointegration. Such studies concentrated on G7 economies. To investigate this further the panel was split into two groups: the G7 and eleven small open economies. For the panel of small open economies strong evidence in favour of cointegration is found. In contrast, there is no evidence of cointegration in a panel that consists purely of the G7 economies.

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Paper provided by Bank of England in its series Bank of England working papers with number 138.

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Date of creation: Jun 2001
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Handle: RePEc:boe:boeewp:138

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Citations

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Cited by:
  1. Matthieu Bussiere & Georgios Chortareas & Rebecca Driver, 2003. "Current Accounts, Net Foreign Assets and the Implications of Cyclical Factors," Eastern Economic Journal, Eastern Economic Association, vol. 29(2), pages 269-286, Spring.
  2. Maurice Obstfeld & Alan M. Taylor, 2002. "Globalization and Capital Markets," NBER Working Papers 8846, National Bureau of Economic Research, Inc.
  3. Byrne, Joseph P. & Nagayasu, Jun, 2008. "Structural Breaks in the Real Exchange Rate and Real Interest Rate Relationship," SIRE Discussion Papers 2008-52, Scottish Institute for Research in Economics (SIRE).
  4. Abhisek Banerjee & Manmohan Singh, 2006. "Testing Real Interest Parity in Emerging Markets," IMF Working Papers 06/249, International Monetary Fund.
  5. Jan J J Groen & Clare Lombardelli, 2004. "Real exchange rates and the relative prices of non-traded and traded goods: an empirical analysis," Bank of England working papers 223, Bank of England.
  6. Georgios Chortareas & George Kapetanios, 2006. "The yen real exchange rate may be stationary after all: evidence from non-linear unit root tests," Bank of England working papers 311, Bank of England.
  7. Monika Blaszkiewicz & Przemek Kowalski & Lukasz Rawdanowicz & Przemyslaw Wozniak, 2004. "Harrod-Balassa-Samuelson Effect in Selected Countries of Central and Eastern Europe," CASE Network Reports 0057, CASE-Center for Social and Economic Research.
  8. Mathias Hoffmann & Ronald MacDonald, 2003. "A Re-examination of the Link between Real Exchange Rates and Real Interest Rate Differentials," CESifo Working Paper Series 894, CESifo Group Munich.
  9. Paresh Kumar Narayan & Russell Smyth, 2006. "The dynamic relationship between real exchange rates, real interest rates and foreign exchange reserves: empirical evidence from China," Applied Financial Economics, Taylor & Francis Journals, vol. 16(9), pages 639-651.
  10. Patrick Minford & David Peel, 2007. "On the Equality of Real Interest Rates Across Borders in Integrated Capital Markets," Open Economies Review, Springer, vol. 18(1), pages 119-125, February.
  11. Akram, Q. Farooq, 2006. "PPP in the medium run: The case of Norway," Journal of Macroeconomics, Elsevier, vol. 28(4), pages 700-719, December.
  12. Alex Luiz Ferreira, 2004. "Are Real Interest Differentials Caused by Frictions in Goods or Assets Markets, Real or Nominal Shocks?," Studies in Economics 0407, Department of Economics, University of Kent.
  13. Levy Yeyati, Eduardo & Schmukler, Sergio L. & Van Horen, Neeltje, 2006. "International financial integration through the law of one price," Policy Research Working Paper Series 3897, The World Bank.
  14. Levy Yeyati, Eduardo & Schmukler, Sergio L. & Van Horen, Neeltje, 2009. "International financial integration through the law of one price: The role of liquidity and capital controls," Journal of Financial Intermediation, Elsevier, vol. 18(3), pages 432-463, July.

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