The role of exchange rate policy in economic development has
been the subject of much debate and controversy in the development
literature. Interest rates and exchange rates are usually viewed as
important in the transmission of monetary impulses to the real economy.
In the short run the standard view of academics and policy-makers is
that a monetary expansion lowers the interest rate and rises the
exchange rate, with these price changes then affecting the level and
composition of aggregate demand. Frequently, these influences are
described as the liquidity effects of monetary expansion, viewed as the
joint effect of providing larger quantities of money to the private
sector. Popular theories of exchange-rate determination also predict a
link between real exchange rates and real interest rate differentials.
These theories combine the uncovered interest parity relationship with
the assumption that the real exchange rate deviates from its long-run
level only temporarily. Under these assumptions, shocks to the real
exchange rate—which are often viewed as caused by shocks to monetary
policy—are expected to reverse themselves over time. This study
investigates the long-run relationship between real exchange rates and
real interest rate differentials using recently developed panel
cointegration technique. Although this kind of relationship has been
studied by a number of researchers,1 very little evidence in support of
the relationship has been reported in the case of developing countries.
For example, Meese and Rogoff (1988) and Edison and Pauls (1993), among
others, used the Engle-Granger cointegration method and fail to
establish a clear long-run relationship in their analysis.
Real Exchange Rates and Real Interest Rate Differentials: A Present Value Interpretation