International real interest rate differentials, purchasing power parity and the behaviour of real exchange rates: the resolution of a conundrum | Zendy

Taylor Mark P. | Zendy; Sarno Lucio | Zendy

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International real interest rate differentials, purchasing power parity and the behaviour of real exchange rates: the resolution of a conundrum

Author(s) -

Taylor Mark P.,

Sarno Lucio

Publication year - 2004

Publication title -

international journal of finance and economics

Language(s) - English

Resource type - Journals

SCImago Journal Rank - 0.505

H-Index - 39

eISSN - 1099-1158

pISSN - 1076-9307

DOI - 10.1002/ijfe.232

Subject(s) - purchasing power parity , economics , interest rate parity , exchange rate , relative purchasing power parity , real interest rate , econometrics , martingale (probability theory) , forward rate , international fisher effect , efficient market hypothesis , interest rate , financial economics , monetary economics , fisher hypothesis , stock market , mathematics , statistics , paleontology , horse , biology

According to one strand of the international finance literature, market efficiency implies that the real exchange rate follows a martingale process, in direct conflict with the long‐run absolute purchasing power parity hypothesis, which requires a stationary real exchange rate process. This conflict between market efficiency and long‐run PPP appears as something of a conundrum. We resolve this conundrum by relaxing the assumption of a constant real interest rate differential and analysing the vector equilibrium correction system linking prices and the exchange rate, and draw out the economic intuition of our result. Copyright © 2004 John Wiley & Sons, Ltd.

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