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

Abstract

This study empirically tests the long-run relationship between real exchange rate and real interest rate (RERI) differentials using quarterly panel data over the period 1993- 2018 employing cointegration methods for a panel of 12 inflation targeting countries. The theoretical relationship of a long-run equilibrium relationship between real exchange rates and interest rate differentials is essentially derived from the Purchasing Power Parity (PPP) and uncovered interest parity theories. This theoretical relationship has become a standard and acceptable theory in open economy macroeconomics. Even so, empirical evidence on this long-run relationship has been mixed. Our study differs from previous studies in two respects. First, we investigate this relationship only for countries that have the same monetary policy framework (inflation targeting) (interest rates and exchange rates are theoretically important in the transmission of monetary impulses to the real economy). Second, we use both multivariate and panel cointegration methods in our investigation. The results show some evidence of cointegration in the country-by-country cases that we investigated using multivariate cointegration tests and weak evidence of cointegration between real exchange rate and real interest rate differentials for the sample of inflation targeting countries using panel cointegration tests. The findings in this study corroborates early works and recent studies on the long-run relationship between real exchange rate and real interest rate differentials. The empirical evidence from this study conclude that there is no clear evidence that the real interest rate – real exchange rate relationship in inflation targeting countries are different from other countries with well-developed financial markets.