Working Paper: NBER ID: w0921
Authors: Robert E. Cumby; Maurice Obstfeld
Abstract: In an open economy, the scope for activist stabilization policy depends on the nature of the lincages between domestic and international markets for goods and assets. Tgo\0important relationships--purchasing power parity and uncovered interest-rate parity--have received extensive empirical atpention in recent years and are fundamental building blocks of several eipirical ex- change rate models. This paper reviews and extends recent econometric findings on these two classical parity relationships and on their corollary, the international equality of expected real interest rates. Econometric tests assuming rationality of expectations are on the whole unfavorable to the classical parity relationships: with few exceptions, they are strongly rejected. A central theme in the review of empirical work is the conditional heteroskedasticity of inflation and exchange rate forecast errors and the bias this statistical problem may impart to tests of inter- national parity relationships. The paper proposes and implements a test for conditional heteroskedasticity which in many cases produces strong evidence that the problem is indeed important.
Keywords: International Economics; Exchange Rates; Interest Rates; Purchasing Power Parity; Uncovered Interest Parity
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Conditional heteroskedasticity (C21) | Validity of tests of international parity relationships (F31) |
| Purchasing power parity (PPP) holds (F31) | Expected real interest rates across countries should be equalized (E43) |
| Nominal interest rates (E43) | Expected inflation rates (E31) |
| Expected inflation rates (E31) | Expected real interest rates across countries (E43) |
| Endogeneity in estimation of relationships (C51) | Violation of assumptions underlying tests (C12) |
| Deviations from classical parity conditions (D59) | Efficacy of monetary policy in influencing real interest rates (E43) |