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Does the nominal exchange rate regime affect the real interest parity condition?

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  • Christian Dreger

Abstract

The real interest parity (RIP) condition combines two cornerstones in international finance, uncovered interest parity (UIP) and ex ante purchasing power parity (PPP). The extent of deviation from RIP is therefore an indicator of the lack of product and financial market integration. This paper investigates whether the nominal exchange rate regime has an impact on RIP. The analysis is based on 15 annual real interest rates and covers a long time span, 1870-2006. Four subperiods are distinguished and linked to fixed and flexible exchange rate regimes: the Gold Standard, the interwar float, the Bretton Woods system and the current managed float. Panel integration techniques are applied to increase the power of the tests, where cross section correlation is embedded via common factor structures. The results suggest that RIP holds as a long run condition irrespectively of the nominal exchange rate regime. However, adjustment towards RIP is affected by both the institutional framework and the historical episode. Half lives of shocks tend to be lower under fixed exchange rates and in the first part of the sample. Although barriers to trade and capital controls have been removed, they did not lead to lower half lives during the managed float.

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Paper provided by FIW in its series FIW Working Paper series with number 064.

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Length: 31
Date of creation: Dec 2010
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Handle: RePEc:wsr:wpaper:y:2010:i:064

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Keywords: Real interest parity; nominal exchange rate regime; panel unit roots; common factors;

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Cited by:
  1. Muhammad Omer & Jakob de Haan & Bert Scholtens, 2012. "Testing Uncovered Interest Rate Parity Using LIBOR," CESifo Working Paper Series 3839, CESifo Group Munich.
  2. Kavita Sirichand & Andrew Vivian & Mark E.Wohar, 2014. "Examining real interest parity: which component reverts quickest and in which regime?," Discussion Paper Series 2014_05, Department of Economics, Loughborough University, revised Jul 2014.
  3. Simpson, Marc W. & Grossmann, Axel, 2014. "An examination of the forward prediction error of U.S. dollar exchange rates and how they are related to bid-ask spreads, purchasing power parity disequilibria, and forward premium asymmetry," The North American Journal of Economics and Finance, Elsevier, vol. 28(C), pages 221-238.

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