Download Relationship Between Real Exchange Rates Real Interest Rate Differentials: The Co-Integration Approach

Relationship Between Real Exchange Rates & Real Interest
Rate Differentials: The Co-Integration Approach
Attaullah Shah1 and Saeed Ur Rehman2
Theoretical literature suggests that there exists a logical
relationship between real effective exchange rates and
real interest rates differentials in economy particularly
when co-integration technique is used. However,
empirical tests have often produced mixed results. This
study uses monthly data from July 1991 to June 2009 of
Pakistan’s economy and uses co-integration technique to
empirically examine the predictions of purchasing power
parity and interest parity theories. The results show that
the two variables are not co-integrated. The findings of
this study are consistent with the study of Edison and
Pauls (1993).
1. INTRODUCTION
The relationship between interest rate and exchange rate has been the focus of
many theoretical and empirical studies for some obvious reasons. One such reason
is the standard prescription of the International Monetary Fund (IMF). The IMF has
been following a strategy of forcing borrowing countries to maintain high interest
rates and let the foreign exchange market free of interventions. The basic idea is that
higher interest rates will entice foreign investors into the country, thereby stabilizing
the exchange rate. However, this policy has been criticized by many theoretical and
empirical researchers. For example, Kashiwabara and Kunimine (1999) conclude in
their study on the Asian financial crisis and the role of IMF that high interest rates
exacerbated the crisis. They further argue that attracting capital into the domestic
market via high interest rates makes future instability in capital inflows more likely. A
fundamental question is that whether or not empirical research lends support to the
role of interest rate in influencing exchange rate? The focus of this study is to look
into empirical association of real exchange rates and real interest rate differentials in
Pakistan’s context because Pakistan has run into balance of payment problems
several times in the recent past and has availed the financing facility of IMF. If the
relationship is found to be missing, it would suggest a major policy shift in the IMF’s
standard prescription of high interest rates and free exchange rate.
The theoretical underpinnings for the relationship of real interest rate differentials
and exchange rate are provided by two well-known concepts in the international
macro-economic i.e. the purchasing power parity (PPP) and interest rate parity
(IRP). These theories and some other more convincing models developed in studies
like Frankel (1993), Edison and Pauls (1993), Meese and Rogoff (1988) etc.
1
Dr. Attaullah Shah, Institute of Management Sciences, Peshawar Email:
[email protected]
2
Saeed Ur Rehman: Pursuing MS Studies at Institute of Management Sciences, Peshawar, Email:
[email protected]
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establish theoretical association between the said variables in logically consistent
ways. However, the relationship has not stood firm to empirical tests.
This paper employs the co-integration technique in order to study the relationship
between the real exchange rates and interest rates differential using data from July
1990 to June 2009. Although great deal of research has been done on this issue in
developed economies, however there is no empirical evidence in developing country
like Pakistan. The plan of the paper is as follows. Section 2 surveys the related
literature. Section 3 discusses the methodology and data. Section 4 discusses the
results and draws comparisons with recent literature. Section 5 concludes the paper.
2. LITERATURE REVIEW
Great deal of research has been done in to study the relationship between real
exchange rates and real interest rates differential. Frankel (1979) used a sample of
monthly observations between July 1974 and February 1978 for mark/dollar
exchange rate and used OLS technique and found that nominal exchange rate is
negatively related to the nominal interest rate differential and is positively related to
expected long run inflation differential. According to Meese and Rogoff (1988) there
is no strong correspondence between real interest rate differentials and real
exchange rates while using monthly data from 1974:02 to 1986:12 for dollar/mark,
dollar/yen and dollar/pound rates. Edison and Pauls (1993) tried to assess the link
between real exchange rates and real interest rate differentials using co-integration
techniques and error-correction models. They used quarterly observations from 1974
to 1990.
Their result showed that that real interest rates and real exchange rates are nonstationary and are not co-integrated. Hoffmann and MacDonald (2000) used
structural VAR over a period of 1978:Q2 to 1997:Q4 to assess the relationship
between the real exchange rate, real output and real interest rate differentials of G-7
countries. They found that there exist co-integrating relationship between the output
and real interest rate differentials and the exchange rate. They used Johansen’s test
for co-integration. According to Chortareas and Driver (2001) there exists valid
stationary relationship between the variables under study. They used tests on a
panel of 18 OECD economies with more than 20 years of quarterly data.
Hoffmann and MacDonald (2003) gives an alternative to the co-integration method,
they propose to estimate a VAR with q in differences. They use the data for G-7
countries over 1978:Q1 to 1997:Q4. By using simple correlation study, they have
shown that the link between changes in the real exchange rate and the level of the
real interest rate differential is identified, at best, in the long run. However, it is also
noteworthy that the level correlations are all negative.
In the light of the literature cited, there exist either no or a negative relationship
between the two variables. The study tests the following hypothesis.
H0: Real Effective Exchange Rates and Interest Rate Differentials series are not Co
integrated.
H1: Real Effective Exchange Rates and Interest Rate Differentials series are Co
integrated.
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3. METHODOLOGY & DATA
Monthly data of real exchange rates and interest rates differentials for the period
starting from July 1991 to June 2009. The data has been acquired from IFS (IMF CD
Version 2010) for International Economies. Before conducting formal analysis, the
data are checked for stationarity in the following steps:
i)
ii)
Augmented Dickey Fuller test is used to check the stationarity or nonstationarity of real effective exchange rates and interest rate differentials. As an
outcome of applying ADF test if series seems non-stationary then series are
made stationary by taking difference. The ADF test uses the following model;
To find out that the data is co-integrated or not the method developed by
Johansen (1988) and Johansen and Juselius (1990) has been used in the
following steps.
a.
b. Obtaining the residuals from regression equation mentioned in step a
and testing it for unit root by using ADF test.
4. STATISTICAL FINDINGS
4.1 Augmented Dickey-Fuller (ADF) test for IRD and REER series.
Table 4.1 Results of ADF Test
Asymptotic p-values
Asymptotic p-values
With Constant
With Constant & trend
IRD
8.786e-021*
8.78e-022*
REER
0.2285
0.02233
*
*We can reject the hypothesis of non-stationarity of series at 5% level of significance.
The result shown in table 4.1 dictates that interest rate differential and real effective
exchange rates are stationary. Hence the series are integrated of order 0.
In order to check these two variables for co-integration the test developed by
Johnson & Engle (1988) has been used.
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Step 1: Co-integrating regression - OLS estimates using the 215 observations
1991:08-2009:06
Dependent variable: REER
Coefficient
std. error
t-ratio p-value
Const
108.549
0.651687
166.6
1.44e-227 ***
IRD
0.156170
0.173105
0.9022 0.3680
Mean dependent var
108.5167
S.D. dependent var
9.537138
Sum squared resid 19390.70
S.E. of regression
9.541288
R-squared
0.003807
Adjusted R-squared -0.000870
Log-likelihood
-789.0272
Akaike criterion
1582.054
Schwarz criterion 1588.796
Hannan-Quinn
1584.778
Rho
0.969336
Durbin-Watson
0.053189
Table 4.2: Augmented Dickey-Fuller test for Uhat including one lag of Uhat
sample size 213
Asymptotic p-values
With Constant
Uhat
0.5154
There is evidence for a co-integrating relationship if:
(a) The unit-root hypothesis is not rejected for the individual variables.
(b) The unit-root hypothesis is rejected for the residuals (uhat) from the Cointegrating regression.
Since we cannot reject the hypothesis of non-stationarity of Uhat series, hence
residuals obtained from co-integration regression are non-stationary. Since individual
series are stationary at same order and residuals from co-integration regression are
non-stationary therefore we can infer that there is no co-integration between the
variables under consideration.
Based on the results shown in Tables 4.1 and 4.2, we cannot reject our null
hypothesis; i.e. the series/variables under consideration are not co-integrated. The
results are consistent with the study of Edison and Pauls (1993).
5. CONCLUSION
In this paper an attempt has been made to examine the relationship between
effective real exchange rates and interest rate differentials by using co-integration
approach while using monthly data from July 1991 to June 2009. Based on statistical
findings this paper concludes that similar to many other researchers like Edison and
Pauls (1993) we could not find the relationship between the variables under
consideration. This argument can also be supported from the co-integration
regression where R-Square of 3.8% shows very less explanatory power for the
explanation of REER. This shows that determination of relationship between REER
and IRD is not possible because there are 96.02% other variables that explain
REER. Hence it is deducted that we have to include some other variables to
establish the relationship between the variables under consideration.
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There are several reasons of no co-integration between REER and IRD, like
continuous fluctuation is exchange rates e.g. high inflation rate in Pakistan as
compared to US, high interest rates as compared to US, instable monetary policies,
poor GDP growth rate, unemployment, poor administrative system, lack of proper
policies and political instability. In order to establish the proper relationship between
the variables under consideration several other macro-economic indicators like
inflation, un-employment rate, GDP, trade balance, industrial growth, and foreign
reserves etc with IRD and find their relationship with REER.
References
1. Frankel, Jeffrey A.(1979): ‘On The Mark: A Theory of Floating Exchange Rates
Based on Real Interest differentials’, American Economic Review, Vol.-69,
Sep., p-610-22.
2. Meese, Richard A. and Kenneth Rogoff (1988): ‘Was It Real? The Exchange
Rate-Interest Rate Differential Relation over the Modern Floating-Rate Period’,
The Journal of Finance, Vol.-XLIII, No.-4(Sep), p-933-48.
3. Edison, Hali J. and B. Dianne Pauls (1993): ‘A Re-Assessment of the
Relationship between Real Exchange Rates and Real Interest Rates: 19741990’, Journal of Monetary Economics, Vol.-31, April, p-165-87
4. MacDonald, Ronald and Mathias Hoffman (2000): ‘A Real Differential View of
Equilibrium Real Exchange Rates and Misalignments’, Center for financial
Studies, Working Paper, No.-2000/08. (http://www.ifk-cfs.de)
5. MacDonald, Ronald and Mathias Hoffman (2003): ‘A Re-Examination of the
Link between Real Exchange Rates and Real Interest Rate Differentials’,
CESifo Working Paper, No.-894, (http://paper.ssrn.com/sol3/del.PDF)
(www.CESifo.de)
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