The dollar and real interest rates
In this paper, we investigate the link between the real foreign exchange value of the dollar and real interest rates since 1979. We argue that it is important to consider the possibility that real exchange rate movements reflect movements of the long-run equilibrium exchange rate as well as real interest differentials. We use a state-space approach to estimate the importance of shifts in the long-run equilibrium exchange rate, the persistence of the ex ante short-term real interest differential, and the effect of this differential on the exchange rate. Using U.S., Canadian, British, German and Japanese data from October 1979 to March 1986, we find that movements in the dollar real exchange rate have been dominated by unanticipated shifts in the expected long-run real exchange rate. Ex ante real interest differentials have not been persistent or variable enough to account for a major part of exchange rate variation. We use Mussa's (1984) rational expectations model of the real exchange rate and the current account to interpret our results.
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Volume (Year): 27 (1987)
Issue (Month): 1 (January)
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References listed on IDEAS
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- William H. Branson, 1985. "Causes of appreciation and volatility of the dollar," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 33-63.
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"Asset markets, exchange rates and the balance of payments,"
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in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 14, pages 679-747
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- Jeffrey Sachs, 1985. "The Dollar and the Policy Mix: 1985," NBER Working Papers 1636, National Bureau of Economic Research, Inc.
- Jeffrey A. Frankel, 1985. "The Dazzling Dollar," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(1), pages 199-217.
- Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
- Fama, Eugene F. & Gibbons, Michael R., 1982. "Inflation, real returns and capital investment," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 297-323.
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- Hamilton, James D, 1985. "Uncovering Financial Market Expectations of Inflation," Journal of Political Economy, University of Chicago Press, vol. 93(6), pages 1224-41, December.
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