Regime linkages in the US/UK real exchange rate–real interest differential relation

Abstract

Using a multivariate regime switching framework and focusing on the period 1921–2002, which is characterized by different nominal exchange rate regimes, and monetary regimes, we find supportive evidence of the US/UK real exchange rate–real interest differential relation, in terms of volatility regime dependence. The two variables are jointly characterized by high volatility during periods of floating exchange rates, and by low volatility during periods of fixed exchange rates, thereby suggesting that the nominal exchange rate regime is the driving force behind the volatility regime switching. Thus, allowing for regime switching in the real exchange rate–real interest differential relation bridges the gap between popular theories of real exchange rate determination, which predict such a relation, and previous empirical studies, which failed to uncover such a relation for the US/UK real exchange rate.