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A Re-examination of the link between Real Exchange Rates and Real Interest Rate Differentials

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  • Mathias Hoffmann
  • Ronald MacDonald

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 reinvestigate the RERI relationship using bilateral real exchange rate data spanning the period 1978 to 1997. We propose an alternative way of investi- gating the relationship using the present value VAR-based test of Campbell and Shiller (1987). Our empirical results provide robust evidence that the RERI relationship is economically signi cant and that the real interest rate di¤erential is a reasonable approximation of the expected rate of depreciation over longer horizons. Although we report a statistical rejection of cross equa- tion restrictions, this can largely be ascribed to the fact that excess returns on a currency have a signi cant degree of medium-run predictability, rather than to a rejection of the RERI. Our findings corroborate Baxter’s (1994) substantive conclusion that there is an important link between real exchange rates and real interest rates at business cycle frequencies.

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Bibliographic Info

Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2007_36.

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Date of creation: Jul 2006
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Handle: RePEc:gla:glaewp:2007_36

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Keywords: Real Exchange Rates; Real Interest Rates; Present Value Model;

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References

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Citations

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Cited by:
  1. Catherine S. F. Ho & M. Ariff, 2008. "The Role of Non-Parity Fundamentals in Exchange Rate Determination: Australia and the Asia Pacific Region," CARF F-Series CARF-F-125, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
  2. Balazs Egert & Ronald MacDonald, 2006. "Monetary Transmission Mechanism in Transition Economies: Surveying the Surveyable," CESifo Working Paper Series 1739, CESifo Group Munich.
  3. 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.
  4. Dette, Holger & Weißbach, Rafael, 2006. "A Bootstrap Test for the Comparison of Nonlinear Time Series - with Application to Interest Rate Modelling," Technical Reports 2006,30, Technische Universität Dortmund, Sonderforschungsbereich 475: Komplexitätsreduktion in multivariaten Datenstrukturen.
  5. Jesús Ferreyra & Jorge Salas, 2006. "The Equilibrium Real Exchange Rate in Peru: BEER Models and Confidence Band Building," Working Papers 2006-006, Banco Central de Reserva del Perú.
  6. Weißbach, Rafael & Ponyatovskyy, Vladyslav & Zimmermann, Guido, 2006. "The Yield of Ten-Year T-Bonds: Stumbling Towards a 'Good' Forecast," Technical Reports 2006,50, Technische Universität Dortmund, Sonderforschungsbereich 475: Komplexitätsreduktion in multivariaten Datenstrukturen.
  7. Mylonidis, Nikolaos & Paleologou, Suzanna-Maria, 2011. "The real uncovered interest parity: The case of Canada and the USA," Journal of Policy Modeling, Elsevier, vol. 33(2), pages 255-267, March.

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