International real interest rate parity with error correction models

Abstract

Under costless financial and commodity arbitrage, incorporation of expectational (relative) purchasing power parity (PPP) into uncovered interest parity results in the equality of real interest rates between two nations, which is referred to as International Fisher-open condition. Expectational PPP implies that exchange rates will move to offset changes in price differentials, whereas uncovered interest parity indicates that arbitrage between world financial markets in the form of international capital flows should ensure that the interest differential between any two countries is the unbiased predictor of the future change in the spot exchange rate. As a result, nominal interest rate differential must be equal to expected inflation differential between two countries. This is to say that real interest rates must be identical between two nations, called the Fisher-open condition. Testing the hypothesis that real interest rates for comparable securities are equal across countries is pivotal on the ground that it provides an important implication for exchange rate determination. The results of previous empirical studies, however, are controversial. Howard and Johnson (1983) demonstrated that PPP, the Fisher open condition, and interest rate parity could not simultaneously hold in a world of taxation. Ben-Zion and Weinblatt (1984) and McClure (1988) also provided the same conclusion. Furthermore, Mishkin (1984a) documented empirical evidence rejecting the hypothesis of the equality of real Eurorates across countries. The joint hypothesis of uncovered interest parity and ex-ante relative PPP were also strongly rejected. However, his test for the independency of the Fisher-open condition, the unbiasedness of forward rate forecasts, and ex-ante relative PPP showed few rejections and high marginal significance levels. As a result, his evidence did not rule out that there was a tendency for real rates to be equal across countries over time.