Resuscitating real interest rate parity: new evidence from panels

Georgios Chortareas, George Kapetanios, Georgios Magkonis

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    Abstract

    This paper considers the real interest rate parity (RIRP) in OECD countries applying a sequential panel selection (SPS) method on alternative panel unit-root tests. Our approach exploits the enhanced power of panels to uncover evidence of stationarity, but also identifies the exact countries for which the RIRP holds in a panel. Moreover, we construct real interest rate measures using alternative approaches, including a Markov regime-switching procedure, which is consistent with the forward-looking nature of inflation expectations formation. Considering US as the benchmark economy, we produce strong evidence of stationarity in real interest rate differentials, which resuscitates RIRP, especially given the inconclusive results in the related literature. Our results are robust to different panel unit-root tests, measures of inflation expectations, and interest rate maturities. The RIRP appears quite resilient in the face of the global financial crisis and the low real interest rate environment after the great recession. The SPS allows to calculate half-lives, which avoid the pitfalls of over/underestimating the speed of adjustment and are lower as compared to the typical estimates in the literature.
    Original languageEnglish
    Article number0
    Pages (from-to)1176-1189
    Number of pages14
    JournalThe European Journal of Finance
    Volume24
    Issue number14
    Early online date29 Nov 2017
    DOIs
    Publication statusPublished - 1 Jan 2018

    Keywords

    • real interest rate parity
    • panel unit-root tests
    • cross-sectional dependence
    • inflation expectations
    • Markov regime switching
    • half-lives

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