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A Re-examination of the Link between Real Exchange Rates and Real Interest Rate Differentials

  • Mathias Hoffmann
  • Ronald MacDonald

The real exchange rate - real interest rate (RERI) relationship is central to most open economy macroeconomic models. However, empirical support for the relationship, especially when cointegrationbased methods are used, is rather weak. In this paper we reinvestigate the RERI relationship using bilateral real exchange rate data spanning the period 1978 to 1997. We first clarify the logic of applying cointegration methods to the RERI and propose an alternative way of testing the relationship. We demonstrate that the failure of earlier analyses to detect a stationary real interest rate is largely due to the low power of the tests employed.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 894.

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Date of creation: 2003
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Handle: RePEc:ces:ceswps:_894
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  1. Campbell, John & Shiller, Robert, 1987. "Cointegration and Tests of Present Value Models," Scholarly Articles 3122490, Harvard University Department of Economics.
  2. Maurice Obstfeld & Alan M. Taylor, 2002. "Globalization and Capital Markets," NBER Working Papers 8846, National Bureau of Economic Research, Inc.
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  4. Ronald MacDonald, 1997. "What Determines Real Exchange Rates? The Long and Short of it," IMF Working Papers 97/21, International Monetary Fund.
  5. Michael B. Devereux & Charles Engel, 2002. "Exchange Rate Pass-Through, Exchange Rate Volatility, and Exchange Rate Disconnect," NBER Working Papers 8858, National Bureau of Economic Research, Inc.
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  7. Kenneth A. Froot & Tarun Ramadorai, 2002. "Currency Returns, Institutional Investor Flows, and Exchange Rate Fundamentals," NBER Working Papers 9080, National Bureau of Economic Research, Inc.
  8. 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.
  9. Edison, Hali J & Melick, William R, 1999. "Alternative Approaches to Real Exchange Rates and Real Interest Rates: Three Up and Three Down," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 4(2), pages 93-111, April.
  10. Olivier Jeanne & Andrew K. Rose, 2002. "Noise Trading And Exchange Rate Regimes," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 537-569, May.
  11. 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.
  12. Gonzalo, Jesus & Granger, Clive W J, 1995. "Estimation of Common Long-Memory Components in Cointegrated Systems," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(1), pages 27-35, January.
  13. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, June.
  14. Maurice Obstfeld & Kenneth Rogoff, 2000. "New Directions for Stochastic Open Economy Models," International Finance 0004002, EconWPA.
  15. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  16. Johansen, Søren & Juselius, Katarina, 1992. "Testing structural hypotheses in a multivariate cointegration analysis of the PPP and the UIP for UK," Journal of Econometrics, Elsevier, vol. 53(1-3), pages 211-244.
  17. Richard Clarida & Jordi Gali, 1994. "Sources of Real Exchange Rate Fluctuations: How Important are Nominal Shocks?," NBER Working Papers 4658, National Bureau of Economic Research, Inc.
  18. Johansen, Soren, 1995. "Likelihood-Based Inference in Cointegrated Vector Autoregressive Models," OUP Catalogue, Oxford University Press, number 9780198774501, March.
  19. Neary, Peter, 1988. "Determinants of the Equilibrium Real Exchange Rate," American Economic Review, American Economic Association, vol. 78(1), pages 210-15, March.
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  27. 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.
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