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

  • Mathias Hoffmann
  • Ronald MacDonald

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 reinvestigate the RERI relationship using bilateral real exchange rate data spanning the period 1978 to 1997. We propose an alternative way of investi- gating the relationship using the present value VAR-based test of Campbell and Shiller (1987). Our empirical results provide robust evidence that the RERI relationship is economically signi cant and that the real interest rate di¤erential is a reasonable approximation of the expected rate of depreciation over longer horizons. Although we report a statistical rejection of cross equa- tion restrictions, this can largely be ascribed to the fact that excess returns on a currency have a signi cant degree of medium-run predictability, rather than to a rejection of the RERI. Our findings corroborate Baxters (1994) substantive conclusion that there is an important link between real exchange rates and real interest rates at business cycle frequencies.

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Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2007_36.

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Date of creation: Jul 2006
Handle: RePEc:gla:glaewp:2007_36
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  2. Obstfeld, Maurice & Rogoff, Kenneth, 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research, Working Paper Series qt5pf7g8sh, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  3. 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.
  4. Baxter, Marianne, 1994. "Real exchange rates and real interest differentials: Have we missed the business-cycle relationship?," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 5-37, February.
  5. Hali J. Edison & B. Dianne Pauls, 1991. "Re-assessment of the relationship between real exchange rates and real interest rates: 1974-1990," International Finance Discussion Papers 408, Board of Governors of the Federal Reserve System (U.S.).
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  7. John Y. Campbell & Robert J. Shiller, 1986. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," NBER Working Papers 2100, National Bureau of Economic Research, Inc.
  8. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-153, March.
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  14. Ronald MacDonald, 1997. "What Determines Real Exchange Rates? The Long and Short of it," IMF Working Papers 97/21, International Monetary Fund.
  15. MacDonald, Ronald, 1998. "What determines real exchange rates?: The long and the short of it," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 8(2), pages 117-153, June.
  16. Proietti, Tommaso, 1997. "Short-Run Dynamics in Cointegrated Systems," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 59(3), pages 405-22, August.
  17. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, March.
  18. Maurice Obstfeld & Alan M. Taylor, 2002. "Globalization and Capital Markets," NBER Working Papers 8846, National Bureau of Economic Research, Inc.
  19. 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 518, Board of Governors of the Federal Reserve System (U.S.).
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  22. Bergstrand, Jeffrey H, 1991. "Structural Determinants of Real Exchange Rates and National Price Levels: Some Empirical Evidence," American Economic Review, American Economic Association, vol. 81(1), pages 325-334, March.
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  24. Georgios E. Chortareas & Rebecca L. Driver, 2001. "PPP and the real exchange rate-real interest rate differential puzzle revisited: evidence from non-stationary panel data," Bank of England working papers 138, Bank of England.
  25. Kenneth A. Froot & Tarun Ramadorai, 2002. "Currency Returns, Institutional Investor Flows, and Exchange Rate Fundamentals," NBER Working Papers 9101, National Bureau of Economic Research, Inc.
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  28. Beveridge, Stephen & Nelson, Charles R., 1981. "A new approach to decomposition of economic time series into permanent and transitory components with particular attention to measurement of the `business cycle'," Journal of Monetary Economics, Elsevier, vol. 7(2), pages 151-174.
  29. 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.
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  31. Cletus C. Coughlin & Kees G. Koedijk, 1990. "What do we know about the long-run real exchange rate?," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 36-48.
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