The real interest rate parity hypothesis : an investigation for developed and emerging markets

This study investigates the existence and causes of real interest rate differential(s) (rid(s) hereafter) across a heterogeneous sample of countries. This is relevant for various reasons. First, the research sheds some light on the extent to which economic authorities are able to pursue independent monetary policy in an open-economy, at least in the short-run. Second, it unveiled interesting characteristics of the dynamics of interest rate differentials. This is important because an indebted economy experiencing persistent rids is prone to face default. Finally, rids indicated the extent of market integration between economies. The adjustment of rids to equilibrium is found to be fast in both emerging and developed economies, a finding that is compatible with the Real Interest Rate Parity Hypothesis. The equilibrium in emerging economies, however, is statistically different from zero pointing out to frictions in either goods or assets markets. We found that the general causes of the differentials are UIP deviations and nominal interest rate differentials. The more specific causes are: 1) persistent reaction of monetary policy to changes in prices and slow adjustment in interest rates; 2) systematic excess returns, possibly induced by anticipated changes in macroeconomic fundamentals and sticky bond prices; 3) large unexpected changes in exchange rates driven by unexpected changes in macroeconomic fundamentals; 4) risk premium. Monetary policy resistance to price and exchange rate changes introduces an element of persistence in equilibrium nominal interest rate differentials which can explain excess returns, in other words, the fact that high interest rates are associated with appreciating exchange rates. Fundamentals can explain excess returns on the basis of systematic excess returns due to interest rate smoothing (sticky bond prices), or large forecast errors associated with unexpected changes in exchange rates. The evidence presented also points out to risk premium as another determinant of bond spreads and, hence, the cause of rids.