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A New Interpretation of the Exchange Rate - Yield Differential Nexus

  • Andrew Wood
  • Jerry Coakley
  • Ana-Maria Fuertes

Empirical studies have had difficulty in establishing the long-run relationship between real exchange rates and real yield differentials predicted by sticky price exchange rate models. We revisit this issue in a nonstationary panel regression framework. This facilitates estimation of a long-run parameter even when the underlying relation-ship is subject to permanent shocks or the variables do not cointegrate. The slope coefficient estimate from a sample of 23 industrialized countries 1973M1-1998M12 has the correct sign and is statistically significant for both short and long-term yields. These results support fundamentals-based models of exchange rate behaviour while permitting real factors to play a role. Moreover, they indicate that capital markets integration is more advanced than hitherto believed. Copyright © 2004 John Wiley & Sons, Ltd.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2003 with number 160.

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Date of creation: 01 Aug 2003
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Handle: RePEc:sce:scecf3:160
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  1. Campbell, John Y & Shiller, Robert J, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Review of Economic Studies, Wiley Blackwell, vol. 58(3), pages 495-514, May.
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  3. Taylor, Alan M, 2001. "Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling and Specification Biases in Mean-Reversion Tests of the Law of One Price," Econometrica, Econometric Society, vol. 69(2), pages 473-98, March.
  4. Philip R. Lane & Gian-Maria Milesi-Ferretti, 2001. "Long-Term Capital Movements," IMF Working Papers 01/107, International Monetary Fund.
    • Philip R. Lane & Gian Maria Milesi-Ferretti, 2002. "Long-Term Capital Movements," NBER Chapters, in: NBER Macroeconomics Annual 2001, Volume 16, pages 73-136 National Bureau of Economic Research, Inc.
  5. Ron Smith & Ana-Maria Fuertes & Jerry Coakley, 2001. "Small Sample Properties of Panel Time-series Estimators with I(1) Errors," Working Papers wp01-08, Warwick Business School, Finance Group.
  6. Peter C.B. Phillips & Hyungsik R. Moon, 1999. "Nonstationary Panel Data Analysis: An Overview of Some Recent Developments," Cowles Foundation Discussion Papers 1221, Cowles Foundation for Research in Economics, Yale University.
  7. Pesaran, M. Hashem & Smith, Ron, 1995. "Estimating long-run relationships from dynamic heterogeneous panels," Journal of Econometrics, Elsevier, vol. 68(1), pages 79-113, July.
  8. Eiji Fujii & Menzie D. Chinn, 2000. "Fin de Siecle Real Interest Parity," NBER Working Papers 7880, National Bureau of Economic Research, Inc.
  9. O'Connell, Paul G. J., 1998. "The overvaluation of purchasing power parity," Journal of International Economics, Elsevier, vol. 44(1), pages 1-19, February.
  10. Nakagawa, Hironobu, 2002. "Real exchange rates and real interest differentials: implications of nonlinear adjustment in real exchange rates," Journal of Monetary Economics, Elsevier, vol. 49(3), pages 629-649, April.
  11. Shleifer, Andrei, 2000. "Inefficient Markets: An Introduction to Behavioral Finance," OUP Catalogue, Oxford University Press, number 9780198292272, March.
  12. Hoffmann, M. & MacDonald, R., 2001. "A real differential view of equilibrium real exchange rate," Discussion Paper Series In Economics And Econometrics 0103, Economics Division, School of Social Sciences, University of Southampton.
  13. 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.
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