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A New Interpretation of the Exchange Rate - Yield Differential Nexus

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  • Andrew Wood
  • Jerry Coakley
  • Ana-Maria Fuertes

Abstract

Empirical studies have had difficulty in establishing the long-run relationship between real exchange rates and real yield differentials predicted by sticky price exchange rate models. We revisit this issue in a nonstationary panel regression framework. This facilitates estimation of a long-run parameter even when the underlying relation-ship is subject to permanent shocks or the variables do not cointegrate. The slope coefficient estimate from a sample of 23 industrialized countries 1973M1-1998M12 has the correct sign and is statistically significant for both short and long-term yields. These results support fundamentals-based models of exchange rate behaviour while permitting real factors to play a role. Moreover, they indicate that capital markets integration is more advanced than hitherto believed. Copyright © 2004 John Wiley & Sons, Ltd.

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2003 with number 160.

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Date of creation: 01 Aug 2003
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Handle: RePEc:sce:scecf3:160

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Keywords: Nonstationary panels; bootstrap; financial market integration; permanent shocks;

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  1. Hoffmann, M. & MacDonald, R., 2001. "A real differential view of equilibrium real exchange rate," Discussion Paper Series In Economics And Econometrics 0103, Economics Division, School of Social Sciences, University of Southampton.
  2. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," International Trade, EconWPA 0012003, EconWPA.
  3. John Y. Campbell & Robert J. Shiller, 1989. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," NBER Working Papers 3153, National Bureau of Economic Research, Inc.
  4. Eiji Fujii & Menzie D. Chinn, 2000. "Fin de Siecle Real Interest Parity," NBER Working Papers 7880, National Bureau of Economic Research, Inc.
  5. Philip Lane & Gian Maria Milesi-Ferretti, 2001. "Long-Term Capital Movements," CEG Working Papers, Trinity College Dublin, Department of Economics 20018, Trinity College Dublin, Department of Economics.
    • Philip R. Lane & Gian Maria Milesi-Ferretti, 2002. "Long-Term Capital Movements," NBER Chapters, in: NBER Macroeconomics Annual 2001, Volume 16, pages 73-136 National Bureau of Economic Research, Inc.
  6. Hali J. Edison & William R. Melick, 1995. "Alternative approaches to real exchange rates and real interest rates: three up and three down," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 518, Board of Governors of the Federal Reserve System (U.S.).
  7. Peter C.B. Phillips & Hyungsik R. Moon, 1999. "Nonstationary Panel Data Analysis: An Overview of Some Recent Developments," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1221, Cowles Foundation for Research in Economics, Yale University.
  8. Nakagawa, Hironobu, 2002. "Real exchange rates and real interest differentials: implications of nonlinear adjustment in real exchange rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 49(3), pages 629-649, April.
  9. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198292272, October.
  10. Pesaran, M.H. & Smith, R., 1992. "Estimating Long-Run Relationships From Dynamic Heterogeneous Panels," Cambridge Working Papers in Economics, Faculty of Economics, University of Cambridge 9215, Faculty of Economics, University of Cambridge.
  11. O'Connell, Paul G. J., 1998. "The overvaluation of purchasing power parity," Journal of International Economics, Elsevier, Elsevier, vol. 44(1), pages 1-19, February.
  12. Taylor, Alan M, 2001. "Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling and Specification Biases in Mean-Reversion Tests of the Law of One Price," Econometrica, Econometric Society, Econometric Society, vol. 69(2), pages 473-98, March.
  13. Jerry Coakley, Ana-Maria Fuertes, Ron Smith, 2001. "Small sample properties of panel time-series estimators with I(1) errors," Computing in Economics and Finance 2001, Society for Computational Economics 191, Society for Computational Economics.
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