Working Paper: NBER ID: w2151
Authors: John Y. Campbell; Richard H. Clarida
Abstract: In this paper, we investigate the link between the real foreign exchange value of the dollar and real interest rates since 1979. We argue that it is important to consider the possibility that real exchange rate movements reflect movements of the long-run equilibrium exchange rate as well as real interest differentials. We use a state-space approach to estimate the importance of shifts in the long-run equilibrium exchange rate, the persistence of the ex ante short-term real interest differential, and the effect of this differential on the exchange rate. Using U.S., Canadian, British, German and Japanese data from October 1979 to March 1986, we find that movements in the dollar real exchange rate have been dominated by unanticipated shifts in the expected long-run real exchange rate. Ex ante real interest differentials have not been persistent or variable enough to account for a major part of exchange rate variation. We use Mussa's (1984) rational expectations model of the real exchange rate and the current account to interpret our results.
Keywords: Dollar; Real Interest Rates; Exchange Rates
JEL Codes: F31; E43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| shocks which increase U.S. real interest rates relative to foreign countries (F31) | appreciation of the long-run equilibrium real exchange rate (F31) |
| shocks which increase U.S. real interest rates relative to foreign countries (F31) | appreciation of the current real exchange rate (F31) |
| real interest differentials (E43) | real exchange rate movements (F31) |
| expected long-run dollar exchange rate (F31) | movements in the dollar real exchange rate (F31) |