In this paper, we explore the relationship between real exchange rates and real interest rate differentials in the United States, Germany, Japan, and the United Kingdom. Contrary to theories based on the joint hypothesis that domestic prices are sticky and monetary disturbances are predominant, we find little evidence of a stable relationship between real interest rates and real exchange rates. We consider both in-sample and out-of-sample tests. One hypothesis that is consistent with our findings is that real disturbances (such as productivity shocks) may be a major source of exchange rate volatility. THIS PAPER INVESTIGATES THE empirical relationship between major currency real exchange rates and real interest rates over the modern (post-March 1973)flexible rate experience. The exchange rates examined here include the dollar/ mark, dollar/yen, and dollar/pound rates. Our two major findings are as follows. First, the data do not indicate a strong correspondence between real interest rate differentials (short-term or long-term) and real exchange rates. This finding appears to conflict with the predictions of most monetary and portfolio balance models of exchange rate determination, though the conflict can be substantially reconciled if aggregate disturbances are primarily real in nature (i.e., changes in productivity, tastes, etc.). It is true that in many cases the sign of the estimated exchange rate-interest rate differential relationship is consistent with the possible predominance of financial market disturbances, but the relationship is not stable enough to be statistically significant. Second, although one does find some evidence of a unit root in both real exchange rates and long-term (but not shortterm) real interest differentials, these two series do not appear to be linearly cointegrated. Hence, the nonstationarity (or near nonstationarity) in the two series cannot be attributed to the same factor.In Section I, we briefly describe a class of small-scale monetary models of exchange rate determination. The importance of this class of models for empirical work derives from its strong predictions about how the exchange rate will move
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