Real Interest Rate Differentials Research Articles

Real interest rate parity in practice: Evidence from Asia‐pacific economies

AbstractThis research investigates the relationship between real interest rate parity and the interest parity puzzle across several economies in the Asia‐Pacific region. Unlike previous studies, we establish a comprehensive theoretical framework for parity and utilize macroeconomic and financial market data from 15 economies in the region to examine it. Our findings indicate that most countries exhibit mild deviations from parity, with real interest rate differentials strongly correlated with changes in the real exchange rate and interest‐exchange rate interaction terms, particularly in middle‐income economies. While interest parity puzzle is also observed in high‐income economies, it is less prevalent in most middle‐income economies. Our analysis reveals that income levels are key drivers of deviations from parity in this model, with interaction terms also playing a crucial role in most cases. The implication here is that for carry trades, investors place significant importance on risk factors, especially in economies with relatively low risk. This insight helps to clarify a puzzle in this area. Therefore, it is imperative that investors should take into account the impact of interest‐exchange rate interaction terms when making carry trade decisions. Lastly, we underscore the significance of ex ante price forecast approaches in achieving parity.

Convenience yield and real exchange rate dynamics: A present‐value interpretation

AbstractIn this paper, we empirically investigate the relationship between the convenience yield of government bonds and the real exchange rates using monthly data from 1999 to 2018. We extend the conventional models, based on the present‐value relationship between the real exchange rate and economic fundamentals, while explicitly considering the role of the convenience yield. Empirical results suggest that our present‐value models can capture the dynamic properties of the real exchange rate documented in the literature, including high persistence, excess volatility and excess co‐movement compared with real interest rate differentials. We also find that the sum of expected convenience yields significantly drives real exchange rate movements. Moreover, we find that foreign exchange swap market friction also plays a role in explaining real exchange rates. Finally, we find that monetary policy at the zero lower bound may be essential in real exchange rate modelling.

Globalization, long memory, and real interest rate convergence: a historical perspective.

This paper investigates whether the real interest rate parity (RIRP) is valid during the three waves of globalizations that occurred in the last 150 years (1870–1914, 1944–1971, 1989 to the present). If any, these periods should favor RIRP, since globalization is a process where economies and financial markets become increasingly integrated into a global economic system. In contrast to the existing literature, we model the departures from RIRP as a long-term memory process and apply fractional integration methods on a sample of real interest rate differentials of seven developed countries: France, Germany, Holland, Italy, Japan, Spain, and the UK across the three globalization waves paired against the USA. We compute impulse response functions (IRF) to gain further insight into the memory characteristics of the RIRP differential processes and provide half-life estimates. We find that deviations from RIRP are mean reverting, providing robust evidence of real interest rate convergence during the three globalization waves. We shed further light on financial and commodity market integration during the three globalization waves by assessing the memory properties of uncovered interest rate parity (UIP) and relative purchasing power parity (PPP) differential processes. We find that deviations from relative PPP and UIP are not always mean-reverting processes. RIRP, relative PPP, and UIP hold simultaneously only in 7 out of 21 cases; RIRP and UIP hold in 11 out of 21 cases; RIRP hold without the support of relative PPP and UIP in 3 out of 21 cases. Thus, the evidence in favor of real interest rate convergence appears to be driven more by UIP than relative PPP. All these results are, to the authors knowledge, new to the literature.

Long-term foreign exchange risk premia and inflation risk

As highlighted by recent literature, long-term foreign exchange risk premia (FRP) of a currency pair tend to covary negatively with short-term real interest rate differentials (RIRD) of the pair. We fit an affine term structure model for 9 major currencies against the US dollar and estimate two components of this covariance: the real risk premia (RRP) component and the inflation risk premia differential (IRPD) component. We find that the IRPD component is significantly negative for all currency pairs in our sample. We propose a macro-finance model to understand the types of shocks that generate such covariance.

Convenience Yield and Real Exchange Rate Dynamics: A Present-Value Interpretation

In this paper, we empirically investigate the relationship between the convenience yield of government bonds and the real exchange rates using monthly data spanning from 1999 to 2018. We extend the conventional models, based on present-value relationship between real exchange rate and economic fundamentals, while explicitly considering the role of the convenience yield. Empirical results suggest that our present-value models are able to capture the dynamic properties of the real exchange rate documented in literature, including high persistence, and excess volatility and co-movement compared with real interest rate differentials. We also find the sum of expected convenience yields significantly drives real exchange rate movements. Moreover, we found that foreign exchange swap market friction also plays a role in explaining real exchange rates. Finally, we identified a deviation with regard to the monetary policy rule, and found that monetary policy at the zero lower bound is also significant for yen--dollar real exchange rate modeling.

Uncovered Interest Parity, Forward Guidance and the Exchange Rate

AbstractUnder uncovered interest parity (UIP), the size of the effect on the real exchange rate of an anticipated change in real interest rate differentials is invariant to the horizon at which the change is expected. Empirical evidence using U.S., euro area and UK data points to a substantial deviation from that invariance prediction: expectations of interest rate differentials in the near (distant) future are shown to have much larger (smaller) effects on the real exchange rate than is implied by UIP. Some possible explanations are discussed.

DETERMINANTS OF REAL EXCHANGE RATE: A BEHAVIOURAL AND FUNDAMENTAL DYNAMIC ANALYSIS IN LATIN AMERICAN COUNTRIES

In this research, we analyze the determinants of the real exchange rate through the fundamentals and behavioral factors, adding other variables as monetary aggregates, economic growth, domestic savings, and productivity. We worked with thirteen Latin American countries from 1980 to 2018 and we used three estimates such as fixed-effects, random-effects, and System GMM. The findings show that although the real exchange rate has a large random component, due to the high coefficient presented by the past values of that variable, there are other variables such as terms of trade, net foreign assets, tax revenue, monetary aggregates, savings rates and productivity, or real interest rate differentials, relative price and economic growth, which can impact negatively and positively respectively. Keywords: Real Exchange Rate, System GMM, Macroeconomics FactorsJEL Classification: E52, E62, C33, C53

Empirical analyses of the relationship between real exchange rate and real interest rate differentials in inflation targeting countries

Empirical analyses of the relationship between real exchange rate and real interest rate differentials in inflation targeting countries

Real interest rate differentials between Central and Eastern European countries and the euro area

Research background: The question of changes in real interest rates differentials between the Euro Area and the CEE countries in the last years is raised because of two main reasons. The first rationale is related to the growing importance of external financial factors for the CEE economies and their monetary autonomy. The second reason is associated with the unprecedented shift in monetary conditions in the EMU, brought about by negative interest rates policy and unconventional policies, and the way it impacts the real rates in the CEE economies.
 Purpose of the article: This paper aims at exploring the relationship between real interest rates in the Euro Area and ten countries: Albania, Bulgaria, the Czech Republic, Hungary, North Macedonia, Moldova, Poland, Romania, Turkey, and Ukraine. The analysis covers the years of 1999-2018, including periods before and after the financial and economic crisis.
 Methods: We employ Markov-switching regression to construct the ex-ante real interest rates series in each country, using monthly data on short-term interest rates and CPI inflation rates. A battery of unit root and stationarity test, both standard and panel ones, is applied to examine the real interest rate parity, also allowing for a structural break in the rate differentials.
 Findings & Value added: We provide detailed evidence on the real interest rates differentials for all of the CEE countries vis-?-vis the Euro Area. We find that, while panel stationarity tests point to the stability of real rate differentials, there are significant dissimilarities across the countries, and the results of the univariate tests are often mixed. At least half of the economies, however, reveal similar patterns of stationarity in real rates relationships. At the same time, we find differentials for the Czech Republic, Hungary, and Poland, countries highly integrated into the EMU economy, to be unstable over time.

Global and regional stock market integration in Asia: A panel convergence approach

This paper examines global and regional stock market integration in Asia at both the aggregate and disaggregate (industry) levels by applying the Phillips-Sul (2007) tests for panel and club convergence. Over both the whole sample (1998m12–2018m3) and the two sub-sample periods (i.e., pre- and post-2008 global financial crisis periods), the Asian stock markets appear to be integrated both globally (vis-à-vis the US) and regionally (vis-à-vis Asia) at the aggregate level, although the speed of convergence has decreased after the crisis. The industry level convergence tests reveals that, notwithstanding the aggregate convergence, there are 3 (i.e., Gas & Oil, Healthcare and Technology) out of 10 industries not exhibiting panel convergence in any sample period; further, no convergence is found for Basic Materials and Consumer Services in the pre-crisis period and Telecommunications and Utilities in the post-crisis period. The club convergence tests show this was due to the existence of convergence clubs, clubs in the turn-around phase, and divergent economies in these industries. Global and regional integration exhibited similar patterns in most cases, although the former appears to be stronger than the latter in the post-crisis period. We also find that trade linkages and stock market development promote Asia's regional stock market integration but not its global integration; real interest rate differentials and the recent financial crisis have slowed down both regional and global integration, while exchange rate risk and openness only affect the former.

The global factor in neutral policy rates: Some implications for exchange rates, monetary policy, and policy coordination

AbstractThis paper highlights some of the theoretical and practical implications for monetary policy and exchange rates that derive specifically from the presence of a global general equilibrium factor embedded in neutral real policy rates in open economies. Using a standard two‐country Dynamic Stochastic General Equilibrium (DSGE) model, we derive a structural decomposition in which the nominal exchange rate is a function of the expected present value of future neutral real interest rate differentials plus a business cycle factor and a purchasing power parity (PPP) factor. Country‐specific “r*” shocks in general require optimal monetary policy to pass these through to the policy rate, but such shocks will also have exchange rate implications, with an expected decline in the path of the real neutral policy rate reflected in a depreciation of the nominal exchange rate. We document a novel empirical regularity between the equilibrium error in the Vector Error Correction Model (VECM) representation of the empirical Holston, Laubach, and Williams (HLW) four‐country r* model and the value of the nominal trade weighted dollar. In fact, the correlation between the dollar and the 12‐quarter lag of the HLW equilibrium error is estimated to be 0.7. Global shocks to r* under optimal policy require no exchange rate adjustment because passing though r* shocks to policy rates “does all the work” of maintaining global equilibrium. We also study a richer model with international spillovers so that in theory there can be gains to international policy cooperation. In this richer model, we obtain a similar decomposition for the nominal exchange rate, but with the added feature that r* in each country is a function of global productivity and business cycle factors even if these factors are themselves independent across countries. We argue that in practice, there could well be significant costs to central bank communication and credibility under a regime of formal policy cooperation, but that gains to policy coordination could be substantial given that r*s are correlated across countries.

The Global Factor in Neutral Policy Rates: Some Implications for Exchange Rates, Monetary Policy, and Policy Coordination

This paper highlights some of the theoretical and practical implications for monetary policy and exchange rates that derive specifically from the presence of a global general equilibrium factor embedded in neutral real policy rates in open economies. Using a standard two country DSGE model, we derive a structural decomposition in which the nominal exchange rate is a function of the expected present value of future neutral real interest rate differentials plus a business cycle factor and a PPP factor. Country specific “r*” shocks in general require optimal monetary policy to pass these through to the policy rate, but such shocks will also have exchange rate implications, with an expected decline in the path of the real neutral policy rate reflected in a depreciation of the nominal exchange rate. We document a novel empirical regularity between the equilibrium error in the VECM representation of the empirical Holston Laubach Williams (2017) four country r* model and the value of the nominal trade weighted dollar. In fact, the correlation between the dollar and the 12 quarter lag of the HLW equilibrium error is estimated to be 0.7. Global shocks to r* under optimal policy require no exchange rate adjustment because passing though r* shocks to policy rates ‘does all the work’ of maintaining global equilibrium. We also study a richer model with international spill overs so that in theory there can be gains to international policy cooperation. In this richer model we obtain a similar decomposition for the nominal exchange rate, but with the added feature that r* in each country is a function global productivity and business cycle factors even if these factors are themselves independent across countries. We argue that in practice, there could well be significant costs to central bank communication and credibility under a regime of formal policy cooperation, but that gains to policy coordination could be substantial given that r*’s are unobserved but are correlated across countries.

Smooth breaks and nonlinear mean reversion in real interest parity: Evidence from East Asian countries

ABSTRACTThis study aims to explore the empirical validity of the real interest rate parity (RIP) hypothesis for East Asian countries using Japan as the base country. To this end, we employ the recently proposed unit root tests of Christopoulos and Leon-Ledesma that account for both multiple smooth structural breaks of unknown form and nonlinear mean reversion in the series. Our empirical results uncover overwhelming evidences in favor of the RIP hypothesis for the whole countries in our sample. More specifically, through a Fourier approximation, it is observed that all real interest rate differentials display a mean-reverting behavior around an infrequently smooth-breaking mean, with the breaks being in accordance with the financial reforms and economic crises witnessed by the countries. Moreover, the degree of mean reversion appears to vary nonlinearly with the size of real interest rate appreciations and depreciations.

REAL INTEREST RATE PARITY AND FOURIER QUANTILE UNIT ROOT TEST

ABSTRACTReal interest rate differentials usually exhibit two properties; structural breaks and asymmetric dynamics. In this paper, we use various types of Quantile Unit Root Test (QURT) which accounts for both properties. Unlike previous research, we reject the unit root in the real interest rate differentials in 18 out of 21 OECD countries as well as in 4 out of 5 BRICS countries using QURT with sharp and smooth breaks.

Resuscitating real interest rate parity: new evidence from panels

ABSTRACTThis paper considers the real interest rate parity (RIRP) in OECD countries applying a sequential panel selection (SPS) method on alternative panel unit-root tests. Our approach exploits the enhanced power of panels to uncover evidence of stationarity, but also identifies the exact countries for which the RIRP holds in a panel. Moreover, we construct real interest rate measures using alternative approaches, including a Markov regime-switching procedure, which is consistent with the forward-looking nature of inflation expectations formation. Considering US as the benchmark economy, we produce strong evidence of stationarity in real interest rate differentials, which resuscitates RIRP, especially given the inconclusive results in the related literature. Our results are robust to different panel unit-root tests, measures of inflation expectations, and interest rate maturities. The RIRP appears quite resilient in the face of the global financial crisis and the low real interest rate environment after the great recession. The SPS allows to calculate half-lives, which avoid the pitfalls of over/underestimating the speed of adjustment and are lower as compared to the typical estimates in the literature.

Is the yen misaligned more during the Abenomics period?

This paper measures the extent to which the real effective exchange rate of the Japanese yen is misaligned from its equilibrium value. The equilibrium value is estimated using the behavioral equilibrium exchange rate (BEER) approach to determine whether the yen is more misaligned during the Abenomics period. Economic fundamentals such as terms of trade, relative price of nontraded to traded goods, net foreign asset ratio over trade volume, and real interest rate differentials are used to assess the equilibrium exchange rate. Because parameter instability is detected for the whole period (1993 Q1–2016 Q2), stable estimation results for the subsample period (2003 Q1–2016 Q2) are used to compute misalignments. The results indicate that the yen was substantially overvalued during the global financial crisis period (2008 Q4–2012 Q4). In contrast, it was undervalued during the Abenomics period (2013 Q1–2016 Q2) but was much less misaligned than in pre-Abenomics periods.

Inflation-targeting and real interest rate parity: A bias correction approach

This paper investigates whether inflation-targeting influences real interest rate parity (RIP) by a bias correction approach under cross-sectional dependence. The recursive mean adjustment (RMA) method proposed by So and Shin (1999) and Shin and So (2001) is employed to correct the downward bias in the panel unit root tests and in the half-life estimates of real interest rate differentials for traded and non-traded goods. The empirical findings differ depending on whether we apply the RMA. More importantly, the empirical results show that as more homogeneous economies become involved in terms of inflation-targeting regime, stronger mean reversion and much a tighter confidence interval are present. Thus, inflation-targeting plays an important role in providing favorable evidence for long-run RIP.

Real interest rate parity in Asian countries: evidence from the quantile unit root test

ABSTRACTThis article studies the real interest rate parity (RIP) for several Asian countries. This is done by examining the stationarity in the real interest rate differentials (rids) with respect to the US using the quantile unit root test. Our results show that rids exhibits unit-root behaviours in the lower quantile levels, and mean reversion in the upper quantile levels. Furthermore, large positive shocks tend to induce strong mean reversion and the adjustment towards the long-run equilibrium level is faster as rids gets larger, with shorter half-lives in the extreme quantile levels.

Real exchange rates and transition economies

In a number of empirical studies, transition economies have been shown to be subject to the Harrod-Balassa-Samuelson effect. This implies that the currencies of these countries have experienced a prolonged appreciation in real terms as their convergence proceeded. In this paper we find that a long-run relationship exists between the real exchange rate, productivity differentials, real interest rate differentials and the capital account for eight transition economies of Central and Eastern Europe, using monthly data over a period which extends from 1996 to 2013. We find that there are two sources of appreciation of the currencies of these countries, namely the Harrod-Balassa-Samuelson effect and the capital account effect, and argue that their significance depends on the type of investment received by the countries. While long-run foreign direct investment enhances productivity, porfolio investment leaves productivity unaffected, so our argument is that the larger foreign direct investment relative to portfolio investment, the greater the contribution of productivity in the determination of the real exchange rate. Moreover, we find that while the variables are linked by a linear long-run equilibrium relationship, adjustment towards equilibrium is nonlinear and is well represented by a smooth transition mechanism where the degree of equilibrium correction is a function of the sign and/or the size of the deviation from equilibrium. Interestingly, we find that a logistic smooth transition model fits well a larger number of countries, by allowing a different response of the real exchange rate to misalignments of different sign.

Does real interest rate parity really hold? New evidence from G7 countries

The purpose of this study is to understand the fulfillment of the real interest rate parity (RIRP) for G7 countries using panel data on short-term real interest rate differentials (RIRD). Two modern econometric approaches, sharp transition and smooth transition, are employed to examine the dynamic processes of RIRP in the work. More specifically, the novel approaches which specify Carrion-i-Silvestre et al.'s (2005) model and the Fourier function are adopted to re-examine the RIRD. Some major findings are summarized as follows. Firstly, the empirical results are remarkably consistent, even when using distinct numéraire countries or/and using alternative definitions of the real interest rates. Moreover, we obtain results indicating RIRP fulfillment in most cases, whether we adopt the panel or univariate stationarity tests. However, we fail to obtain the strong evidence in favor of RIRP by the Narayan and Popp (2010) unit root test.