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The real exchange rate and real interest differentials: the role of nonlinearities
Author(s) -
Mark Nelson C.,
Moh YoungKyu
Publication year - 2005
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.279
Subject(s) - economics , linkage (software) , econometrics , nonlinear system , exchange rate , real interest rate , interest rate parity , interest rate , liberian dollar , differential (mechanical device) , pound (networking) , macroeconomics , computer science , finance , chemistry , physics , quantum mechanics , world wide web , biochemistry , engineering , gene , aerospace engineering
Recent empirical work has shown the importance of nonlinear adjustment in the dynamics of real exchange rates and real interest differentials. This work suggests that the tenuous empirical linkage between the real exchange rate and the real interest differential might be strengthened by explicitly accounting for these nonlinearities. We pursue this strategy by pricing the real exchange rate by real interest parity. The resulting first‐order stochastic difference equation gives the real exchange rate as the expected present value of future real interest differentials which we compute numerically for three candidate nonlinear processes. Regressions of the log real US dollar prices of the Canadian dollar, deutschemark, yen and pound on the fundamental values implied by these nonlinear models are used to evaluate the linkage. The evidence for linkage is stronger when these present values are computed over shorter horizons than for longer horizons. Copyright © 2005 John Wiley & Sons, Ltd.