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

• Published in: African journal of business and economic research Vol. 15; no. 1; pp. 7 - 25
• Main Authors: Breitenbach, Marthinus C., Kasongo, Axel T., Zerihun, Mulatu F.
• Format: Journal Article
• Language: English
• Published: Adonis & Abbey Publishers 01.03.2020; Sabinet Online
• Subjects: Financial markets; Foreign exchange; Inflation (Finance); Inflation targeting countries; Mexico; Monetary policy; Multivariate; Panel Cointegration; Prices and rates; Purchasing power parity; Real Exchange Rate – Real Interest Rate Differentials; Real Interest Rate Parity; RERI Model; South Africa; United Kingdom; Mexico; South Africa; United Kingdom
• ISSN: 1750-4554; 1750-4562
• DOI: 10.31920/1750-4562/2020/15n1a1

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 corroborate 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 concludes 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. From a policy perspective, real interest rate differentials are not a good predictor of real exchange rates in inflation-targeting countries.