Real Interest Rates Linkages Between the US and UK in the Postwar Period

Abstract

This paper addresses the issue of real interest rate linkages between the UK and the US during the postwar period. We use a bivariate Markov switching vector error correction model, which accounts for both the regime switches in the real interest rates and their long-run cointegration properties over that period. We find strong evidence of two volatility regimes, namely a high volatility and a low volatility regime, jointly characterising the US and the UK real interest rates. Evidence is found of high volatility regime dependence between the two real interest rates. In addition, there is evidence of regime-dependent Granger causality: the US real interest rate Granger causes the UK only in the regime of high volatility. Regime-dependent impulse response analysis reveals that during the high volatility regime, the responses of each real interest rate to an exogenous shock to the other are more persistent than in the low volatility regime.