Given essentially perfect capital mobility, Australian interest rates and the expected exchange rate change should satisfy international arbitrage conditions. We examine an arbitrage condition for a US investor, with a view to explaining the large short-term real interest differential between Australia and the US since late 1984. We have some evidence for a risk premium until late 1985. Since than, we explain the differential as a result of foreign exchange market inefficiency or as a consequence of the market having continually and rationally expected significant real devaluation of the $A. We provide evidence for both these explanations and draw implications for the current debate on Australia's external imbalance.
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