NBER WORKING PAPER SERIES
ARE REAL INTEREST RATES EQUAL ACROSS COUNTRIES?
AN F1PIRICAL
INVESTIGATION OF INTERNATIONAL
PARITY CONDITIONS
Frederic S. Mishkin
Working Paper No. iO18
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge MA 02138
December 1982
I thank for their helpful comments: Robert Cumby, Thomas Doan,
Robert Gordon, Fumlo Hayashi, Craig Hakkio, Marjorie McElroy,
Michael Mussa, Michael Parkin and the participants in workshops at
the University of Liverpool Seminar in Open Econoxry Macroeconomics,
the Board of Governors of the Federal Reserve, the University of
Illinois, Champaign—Urbana, Northwestern University and the
University of Western Ontario. The National Science Foundation and
the Sloan Foundation have provided research support. The research
reported here is part of the NBER's research program in Economic
Fluctuations. Any opinions expressed are those of the author and
not those of the National Bureau of Economic Research.
NBER Working Paper #1048
December 1982
Are Real Interest Rates Equal Across
Countries? An Empirical Investigation of
International Parity Conditions
ABSTRACT
The proposition that real rates are equal across countries is worth
studying because it is central to our understanding of open economy macro-
economics and because it is also an Important issue to policy makers. If it
is true, then domestic monetary authorities have no control over their real
rate relative to the world rate, limiting the impact of their stabilization
policies. In addition, as Feldstein has pointed Out, unless real rates can
differ across countries, policies directed at increasing domestic savings
cannot increase the rate of capital formation and hence productivity. The
equality of real rates is also worth investigating, because it is intimately
linked to and provides information on the basic parity conditions featured
so prominently in open economy macro models.
This paper conducts empirical tests of the equality of real rates and
other parity conditions across countries using euro rate data over the
1967—Il to 1979—li sample period. The empirical evidence strongly rejects
the hypothesis of the equality of real euro rates across countries. The
joint hypotheses of uncovered interest parity and ex ante relative PPP, or
the unbiasedness of forward rate forecasts and ex ante relative PPP, are also
strongly rejected. Yet independent tests of uncovered interest parity, the
unbiasedness of forward rate forecasts and ex ante relative PPP yield few
rejections and high marginal significance levels. The evidence suggests that
it is worth studying open economy models which allow: 1) domestic real rates
to differ from world rates, 2) time varying risk premiums in the forward
market or 3) deviations from ex ante relative purchasing
power parity.
The evidence also leaves open the possibility for policy makers to exert
some control over their domestic real rate relative to those in the rest
of the world. However, the evidence does not rule out that there is a
tendency for real rates across countries to equalize over time, and this
is an important topic for further research.
Frederic S. Mishkin
Department of Economics
Northwestern University
Evanston, Illinois 60201
(312) 492—5690
I. Introduction
The relationship of real interest rates across countries is of central
importance to our understanding of open economy macroeconomics. In models
where there is costless international arbitrage In goods and financial assets,
real interest rates for comparable securities should be equal across countries.
This has been a feature of much of the early research in the monetary approach
to exchange rates: e.g. Frenkel (1976) and Bilson (1978). However, more recent
theoretical models in the exchange rate literature, such as Dornbusch (1976),
Frenkal. (1979) and Mussa (1982), depend on differing real rates between coun-
tries in the short—run.
The proposition that real rates are equal across countries is worth study-
ing because it sheds light on these theoretical models and because it is also
an important issue to policy makers. If it is true, then domestic monetary
authorities have no control over their real rate relative to the world rate,
limiting the impact of their stabilization policies. In addition, as Feldstein
(1982) has pointed out, unless real rates can differ across countries, policies
directed at increasing domestic savings cannot increase the rate of capital
formation and hence productivity. We shall also see that the equality of real
rates is also worth investigating, because it is intimately linked to and pro-
vides information on the basic parity conditions featured so prominently in
open economy macro models.
This paper conducts empirical tests of the equality of real rates across
countries using euro rate data over the 1967—Il to 1979—Il sample period. The
next section develops the methodology of the tests. It is then followed by a
discussion of the data and the empirical results. The final section summarizes
the empirical evidence and provides some concluding remarks.
—2—
II. The Methodology of the Tests
Each country's real rate of interest for one period euro bonds is de-
fined from the Fisher (1930) equation
(1)
rr +
where
=
The
nominal interest rate earned on a one period bond denominated
in that country's currency, at time t ——
i.e.
it is the nominal
return for holding the one—period bond from t—l to t,
rr =
the
country's rate of inflation from t —
1
to t expected at
time t —
1,
rr =
the
one—period real rate of
interest.1
tNote that this definition of a country's real rate matches up the euro secur-
ity denominated in its currency with its inflation rate. Clearly, a
domestic
resident might be interested in the real rate obtained by purchasing a euro
security denominated in a foreign currency. However, given that uncovered
interest parity holds, in this case he will earn the same real return.
As
will become obvious in the next section, uncovered interest parity is intimately
related to the equality of real rates across countries and thus it is only neces-
sary to test the equality of real rates using the definition
above.
—3—
Hence, the real interest rate,
is
just the difference between the
nominal interest rate and the expected inflation rate:2 it is the real
return from holding the one—period euro bond from t—1 to t which is
pected at time t—1. Because the real rate is a return expected at the
beginning of the period, it is also frequently referred to as the cx ante
real rate. The more precise terminology is used to differentiate it from
the cx post real rate, namely, the actual real return from holding the one—
period euro bond from t—1 to t. It equals the nominal interest rate minus
the actual inflation rate from t—1 to t and can be written as
(2) eprr =
rr
—
(1r
—
ir)
=
rr
—
where
eprr =
the
one—period ex post real rate for the euro bond
maturing at time t,
=
the
actual inflation rate from t —
1
to t,
=
— rre
=
'the
forecast error of inflation.
Note that for expositional convenience, the ex ante real rate is always re-
ferred to as the real rate throughout this paper, while the ex post real rate
always refers to the variable defined in equation (2).
The critical assumption behind the methodology developed here is the
rationality of inflation expectations in the euro bond market, which yields
the condition
returns, inflation and interest rates in the empirical work are contin-
uously compounded so that the usual additional second order term is not
necessary in the Fisher equation (1). Note that if holding period returns
are used in the empirical work here rather than continuously compounded
returns, there is almost no change in the results.