Why Are Real Interest Rates Not Equalized Internationally?

Abstract

1. IntroductionInternational financial economists are intensely concerned with several parity conditions that relate goods prices and asset returns across countries. These include purchasing power parity (PPP), interest rate parity (IRP), and variations of these two, such as relative PPP, ex ante PPP, and real interest rate parity (RIP). Each of these parity conditions measures a degree of integration between the economies of the world. The greater the economic integration across countries, the greater the likelihood that the more restrictive of these parity conditions will have empirical support. For example, the strict PPP hypothesis implies that aggregate price levels will be equal in terms of a common currency. This condition is very stringent because it does not allow for even temporary deviations from the equilibrium condition.1 A less restrictive version is long-run PPP, where price levels, measured in a common currency, across countries converge over some period of time, may be a very long period of time. Recognizing all of the impediments that keep strict PPP from holding, economists have put their efforts in studying the long-run version of this equilibrium condition.There is a relatively large literature examining the equality of real interest rates internationally.2 In all of these studies, the real interest rate is defined by the Fisher equation. These studies then go on to estimate and test for the simultaneous existence of uncovered interest parity (UIP), which is also called the open-economy Fisher relation, and ex ante PPP (EAPPP), the other conditions sufficient for RIP. The problem in this strategy is that the Fisher equation may not hold. Many studies have been devoted to examining the validity of the Fisher relationship for both the U.S. and other economies.3 The results of this line of inquiry have been decidedly mixed. Even if the Fisher relation does hold, it is unlikely that the Fisher effect will be one-for-one, as implied by defining the real interest rate from the simple Fisher equation. Both Mundell-Tobin and tax effects can drive a wedge between inflation expectations and the effect on nominal interest rates.4 It would seem more appropriate to treat the Fisher relation as another testable parity condition than as an assumption.In this study, we examine the underlying parity conditions sufficient for RIP, treating them as hypotheses to be tested. The four parity conditions or equilibrium relationships upon which RIP is predicated, uncovered interest parity (UIP), ex ante PPP (EAPPP), the Fisher relation in each country (i.e., the Fisher relation in country A and the Fisher relation in country B), imply time series implications for the observable variables. Specifically, if any of the nominal interest rates or inflation rates can be characterized as integrated variables, evidence of which we will provide, then the four parity conditions imply one common stochastic trend between them. Therefore, an initial examination of the sufficient conditions for RIP should include a test for a unit root in the observable variables and then a test for the number of common stochastic trends in a given RIP system.Because the power of univariate unit root and stationarity tests is notoriously low, many exploit the power gains available by using panel tests. However, there are serious drawbacks to some of these panel unit root tests, for example, O'Connell (1998), Taylor and Sarno (1998), and Breuer, McNown, and Wallace (2001). We overcome these drawbacks by taking advantage of recent innovations in univariate and multivariate unit root tests that have substantially greater power to reject a false null but are not subject to the size distortions associated with some popular panel-based tests. Our use of these methods leads us to conclude that each RIP system analyzed can be characterized, to some degree, as a system of integrated variables that share more than one common trend. …