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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 Baxter’s (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
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Handle: RePEc:gla:glaewp:2007_36
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  17. Cletus C. Coughlin & Kees 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.
  18. Grilli, Vittorio & Roubini, Nouriel, 1992. "Liquidity and exchange rates," Journal of International Economics, Elsevier, vol. 32(3-4), pages 339-352, May.
  19. 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.
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  24. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  25. 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.
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  29. Edison, Hali J. & Pauls, B. Dianne, 1993. "A re-assessment of the relationship between real exchange rates and real interest rates: 1974-1990," Journal of Monetary Economics, Elsevier, vol. 31(2), pages 165-187, April.
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  31. 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.
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  33. 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.
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