Real Interest Rate Parity under Regime Shifts: Evidence for Industrial Countries

We use recently developed cointegration tests that determine endogenously the regime shift to test for bilateral real interest rate convergence (real interest rate parity) in the G7 against the US in the 1974-1995 period. In contrast with previous studies that employed classical regression analysis and standard cointegration tests, our innovative approach provides strong evidence in favour of bilateral real interest rate convergence between the US and several countries in our sample, in particular for short-term real interest rates. Our results highlight the fact that for a number of countries in our sample (Canada and the UK) monetary policy can act as a stabilisation policy tool through its effect on domestic long-term real interest rates while for others (France and Germany) long-term real interest rate changes are significantly influenced by the US monetary policy stance.