Real exchange rates and real interest rate differentials: a present value interpretation

Although the real exchange rate - real interest rate (RERI) relationship is central to most open economy macroeconomic models, empirical support for the relationship is generally found to be rather weak. In this paper we re-investigate the RERI relationship using bilateral U.S. real exchange rate data spanning the period 1978 to 2007. Instead of testing one particular model, we build on Campbell and Shiller (1987) to propose a metric of the economic significance of the relationship. Our empirical results provide robust evidence that the RERI link is economically significant and that the real interest rate differential is a reasonable approximation of the expected rate of depreciation over longer horizons.