Abstract:
The real interest parity (RIP) condition combines two cornerstones in international finance, uncovered interest parity (UIP) and ex ante purchasing power parity (PPP). The extent of deviation from \{RIP\} is therefore an indicator of the lack of product and financial market integration. This paper investigates whether the nominal exchange rate regime has an impact on RIP. The analysis is based on 15 annual real interest rates and covers a long time span, 1870–2006. Four subperiods are distinguished and linked to fixed and flexible exchange rate regimes: the Gold Standard, the interwar float, the Bretton Woods system and the current managed float. Panel integration techniques are applied to increase the power of the tests, where cross section correlation is embedded via common factor structures. The results suggest that \{RIP\} holds as a long run condition irrespectively of the nominal exchange rate regime. However, adjustment towards \{RIP\} is affected by both the institutional framework and the historical episode. Half lives of shocks tend to be lower under fixed exchange rates and in the first part of the sample. Although barriers to trade and capital controls have been removed, they did not lead to lower half lives during the managed float.
Additional Information:
This is the postprint of an article published in the North American Journal of Economics and Finance 21 (2010), 3, p. 274‐285, available online at: http://dx.doi.org/10.1016/j.najef.2010.01.001. This publication was produced as part of the FINESS project, funded by the European Commission through the 7th Framework Programme under contract no. 217266 (http://www.finess-web.eu/).