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

Mathias Hoffmann and Ronald MacDonald

Working Papers from Business School - Economics, University of Glasgow

Abstract: 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.

Keywords: Real Exchange Rates; Real Interest Rates; Present Value Model (search for similar items in EconPapers)
JEL-codes: E43 F31 F41 (search for similar items in EconPapers)
Date: 2006-07
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Working Paper: A Re-examination of the Link between Real Exchange Rates and Real Interest Rate Differentials (2003)
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Persistent link: https://EconPapers.repec.org/RePEc:gla:glaewp:2007_36

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