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Testing Real Interest Parity in Emerging Markets

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  • Abhisek Banerjee
  • Manmohan Singh
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    Abstract

    The paper finds significant deviations between short-term emerging market real interest rates and world real interest rates primarily due to the inflationary expectations of the local investor base. We test for long-run real interest convergence in emerging markets using a time varying panel unit root test proposed by Pesaran to capture the improved macro-economic fundamentals since early 1990s. We also estimate the speed of convergence in the presence of a shock. The paper suggests that real interest rates in the emerging markets show some convergence in the long run but real interest parity does not hold. Our results also find that the speed of adjustment of real rates to a shock is estimated to differ significantly across the emerging markets. Measured by their half-life, some emerging markets in Asia, E.Europe and S.Africa, where real interest rates are generally low, take much longer to adjust than where real interest rates are generally high (Latin America, Turkey). From a policy perspective, encouraging foreign investors to take direct exposure at the short end of the local debt market could lower the real interest rates in some emerging markets.

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    Bibliographic Info

    Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/249.

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    Length: 20
    Date of creation: 01 Nov 2006
    Date of revision:
    Handle: RePEc:imf:imfwpa:06/249

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    Related research

    Keywords: Real interest rates; Adjustment process; Foreign investment; Economic models; real interest rate; inflation; investors; real rates; foreign investors; nominal interest rates; interest differentials; real exchange rates; inflationary expectations; monetary policy; real money; average inflation; actual inflation; nominal interest rate; inflation rates; monetary economics; inflation rate; risk premium; inflation data; global capital; rational expectations; international capital market; measure of inflation;

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    References

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    1. Adrian Blundell-Wignall & Frank Browne, 1991. "Increasing Financial Market Integration, Real Exchange Rates and Macroeconomic Adjustment," OECD Economics Department Working Papers 96, OECD Publishing.
    2. Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
    3. Robert E. Cumby & Maurice Obstfeld, 1982. "International Interest-Rate and Price-Level Linkages Under Flexible Exchange Rates: A Review of Recent Evidence," NBER Working Papers 0921, National Bureau of Economic Research, Inc.
    4. Frederic S. Mishkin, 1982. "Are Real Interest Rates Equal Across Countries? An Empirical Investigation of International Parity Conditions," NBER Working Papers 1048, National Bureau of Economic Research, Inc.
    5. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412 National Bureau of Economic Research, Inc.
    6. Obstfeld, Maurice & Rogoff, Kenneth S., 1995. "Exchange Rate Dynamics Redux," Scholarly Articles 12491026, Harvard University Department of Economics.
    7. Modjtahedi, Bagher, 1988. "Dynamics of real interest differentials : An empirical investigation," European Economic Review, Elsevier, vol. 32(6), pages 1191-1211, July.
    8. Guy Meredith & Menzie D. Chinn, 1998. "Long-Horizon Uncovered Interest Rate Parity," NBER Working Papers 6797, National Bureau of Economic Research, Inc.
    9. Ronald MacDonald & Jun Nagayasu, 2000. "The Long-Run Relationship Between Real Exchange Rates and Real Interest Rate Differentials: A Panel Study," IMF Staff Papers, Palgrave Macmillan, vol. 47(1), pages 5.
    10. Andrew K. Rose & Robert P. Flood, 2001. "Uncovered Interest Parity in Crisis," IMF Working Papers 01/207, International Monetary Fund.
    11. Georgios E. Chortareas & Rebecca L. Driver, 2001. "PPP and the real exchange rate-real interest rate differential puzzle revisited: evidence from non-stationary panel data," Bank of England working papers 138, Bank of England.
    12. Breedon, Francis & Henry, Brian & Williams, Geoffrey, 1999. "Long-Term Real Interest Rates: Evidence on the Global Capital Market," Oxford Review of Economic Policy, Oxford University Press, vol. 15(2), pages 128-42, Summer.
    13. Alex Luiz Ferreira & Miguel León-Ledesma, 2003. "Does the Real Interest Parity Hypothesis Hold? Evidence for Developed and Emerging Markets," Studies in Economics 0301, Department of Economics, University of Kent.
    14. Evans, Paul & Karras, Georgios, 1996. "Convergence revisited," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 249-265, April.
    15. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
    16. Mark, Nelson C., 1985. "Some evidence on the international inequality of real interest rates," Journal of International Money and Finance, Elsevier, vol. 4(2), pages 189-208, June.
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    Cited by:
    1. Amornthum, Somchai & Bonham, Carl S., 2011. "Financial integration in the pacific basin region: RIP by PANIC attack?," Journal of International Money and Finance, Elsevier, vol. 30(6), pages 1019-1033, October.
    2. Baharumshah, Ahmad Zubaidi & Soon, Siew-Voon & Boršič, Darja, 2013. "Real interest parity in Central and Eastern European countries: Evidence on integration into EU and the US markets," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 25(C), pages 163-180.
    3. Stazka, Agnieszka, 2008. "International parity relations between Poland and Germany: a cointegrated VAR approach," MPRA Paper 24057, University Library of Munich, Germany.
    4. Baharumshah, Ahmad Zubaidi & Soon, Siew-Voon & Hamzah, Nor Aishah, 2013. "Parity reversion in real interest rate in the Asian countries: Further evidence based on local-persistent model," Economic Modelling, Elsevier, vol. 35(C), pages 634-642.
    5. Pasricha, Gurnain Kaur, 2008. "Imperfect Competition in Financial Markets and Capital Controls: A Model and a Test," MPRA Paper 12125, University Library of Munich, Germany.

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