Although the real exchange rate - real interest rate (RERI) relationship is central to most open economy macroeconomic models, empirical support for the relationship is generally found to be rather weak. In this paper we re-investigate the RERI relationship using bilateral U.S. real exchange rate data spanning the period 1978 to 2007. Instead of testing one particular model, we build on Campbell and Shiller (1987) to propose a metric of the economic significance of the relationship. Our empirical results provide robust evidence that the RERI link is economically significant and that the real interest rate differential is a reasonable approximation of the expected rate of depreciation over longer horizons.
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Paper provided by Institute for Empirical Research in Economics - IEW in its series IEW - Working Papers with number
iewwp404.
Find related papers by JEL classification: E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates F31 - International Economics - - International Finance - - - Foreign Exchange F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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