Real interest rates and the cost of capital: A comparison of the United States and Japan

Abstract

Previous studies have reported a lower cost of capital in Japan than in the United States and attributed the difference to lower real interest rates in Japan. This paper argues that the approach employed in previous studies is biased in favor of the hypothesis that Japanese capital costs are lower. The paper employs an alternative approach. It presents rational expectations tests of the hypothesis that real riskless interest rates are equal across the two countries. The hypothesis that real riskless rates are equal is rejected by data from the period 1976–1985. Although real riskless rates are not equal, the difference favored the U.S. as often as Japan, and by equal orders of magnitude during the decade 1976–1985. The results therefore do not support the nation that Japan has consistently benefitted from lower costs of capital over the decade. Forward parity and ex ante purchasing power parity are also rejected by the data, though these rejections need not imply unexploited financial market opportunities and therefore cannot be said to have caused the differences in real interest rates.