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Real Exchange Rates and the Globalisation of Financial Markets

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  • Adrian Blundell-Wignall

    (Reserve Bank of Australia)

  • Frank Browne

    (Organisation for Economic Co-operation and Development)

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    Abstract

    A presumption in much of the earlier literature on real exchange rates suggests their behaviour is decoupled from fundamentals. This paper develops a theoretical model which allows for increased globalisation and integration of international financial markets in a world where goods markets are not perfectly integrated. Both cumulated current account balances and real interest differentials may be non-stationary within this framework. Appropriate portfolio diversification as net foreign asset positions diverge implies that the real exchange rates should be cointegrated with real interest differentials and net foreign asset (or liability) positions. Thus, for example, a cumulating overall current account surplus should lead to long-run appreciation of a country’s bilateral real exchange rate with any other country (given expected net returns) for portfolio diversification reasons. Real interest differentials, on the other hand, have an ambiguous impact on long-run real exchange rates. Empirical tests of this model show that three out of four major real exchange rates are cointegrated with these “fundamentals” variables. The underlying assumptions of the model – increasing financial integration and lack of goods market equilibrium – are supported by a series of supplementary tests.

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    File URL: http://www.rba.gov.au/publications/rdp/1992/pdf/rdp9203.pdf
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    Bibliographic Info

    Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9203.

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    Date of creation: Mar 1992
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    Handle: RePEc:rba:rbardp:rdp9203

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    1. Adler, Michael & Lehmann, Bruce, 1983. " Deviations from Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 38(5), pages 1471-87, December.
    2. Corbae, Dean & Ouliaris, Sam, 1988. "Cointegration and Tests of Purchasing Power Parity," The Review of Economics and Statistics, MIT Press, vol. 70(3), pages 508-11, August.
    3. Kenneth A. Froot and Jeffrey A. Frankel., 1988. "Forward Discount Bias: Is It an Exchange Risk Premium?," Economics Working Papers 8874, University of California at Berkeley.
    4. Charles Engel & Kenneth Kletzer, 1987. "Saving and Investment in an Open Economy with Non-Traded Goods," NBER Working Papers 2141, National Bureau of Economic Research, Inc.
    5. Robert E. Cumby & Frederic S. Mishkin, 1987. "The International Linkage of Real Interest Rates: The European - U.S. Connection," NBER Working Papers 1423, National Bureau of Economic Research, Inc.
    6. Maurice Obstfeld, 1986. "How Integrated are World Capital Markets? Some New Tests," NBER Working Papers 2075, National Bureau of Economic Research, Inc.
    7. McCallum, Bennett T, 1976. "Rational Expectations and the Natural Rate Hypothesis: Some Consistent Estimates," Econometrica, Econometric Society, vol. 44(1), pages 43-52, January.
    8. Jeffrey D. Sachs, 1985. "The Dollar and the Policy Mix: 1985," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(1), pages 117-197.
    9. Feldstein, Martin & Horioka, Charles, 1980. "Domestic Saving and International Capital Flows," Economic Journal, Royal Economic Society, vol. 90(358), pages 314-29, June.
    10. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
    11. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
    12. Mishkin, Frederic S, 1984. " Are Real Interest Rates Equal across Countries? An Empirical Investigation of International Parity Conditions," Journal of Finance, American Finance Association, vol. 39(5), pages 1345-57, December.
    13. Aliber, Robert Z, 1973. "The Interest Rate Parity Theorem: A Reinterpretation," Journal of Political Economy, University of Chicago Press, vol. 81(6), pages 1451-59, Nov.-Dec..
    14. Frankel, Jeffrey A., 1989. "Quantifying International Capital Mobility in the 1980s," Department of Economics, Working Paper Series qt4fw7c7bh, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    15. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
    16. Frankel, Jeff & Froot, Ken, 1986. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," Department of Economics, Working Paper Series qt1972q8wm, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    17. Meese, Richard, 1990. "Currency Fluctuations in the Post-Bretton Woods Era," Journal of Economic Perspectives, American Economic Association, vol. 4(1), pages 117-34, Winter.
    18. Meese, Richard A & Rogoff, Kenneth, 1988. " Was It Real? The Exchange Rate-Interest Differential Relation over the Modern Floating-Rate Period," Journal of Finance, American Finance Association, vol. 43(4), pages 933-48, September.
    19. Michael R. Darby, 1983. "Movements in Purchasing Power Parity: The Short and Long Runs," NBER Chapters, in: The International Transmission of Inflation, pages 462-477 National Bureau of Economic Research, Inc.
    20. Maurice Obstfeld, 1982. "Exchange Rates, Inflation and the Sterilization Problem: Germany, 1975-1981," NBER Working Papers 0963, National Bureau of Economic Research, Inc.
    21. Adrian Blundell-Wignall & Frank Browne, 1991. "Increasing Financial Market Integration, Real Exchange Rates and Macroeconomic Adjustment," OECD Economics Department Working Papers 96, OECD Publishing.
    22. Murphy, Robert G., 1986. "Productivity shocks, non-traded goods and optimal capital accumulation," European Economic Review, Elsevier, vol. 30(5), pages 1081-1095, October.
    23. Jeffrey Sachs, 1985. "The Dollar and the Policy Mix: 1985," NBER Working Papers 1636, National Bureau of Economic Research, Inc.
    24. repec:fth:harver:1463 is not listed on IDEAS
    25. Jeffrey A. Frankel & Kenneth A. Froot, 1985. "Using Survey Data to Test Some Standard Propositions Regarding Exchange Rate Expectations," NBER Working Papers 1672, National Bureau of Economic Research, Inc.
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