Real interest parity: Evidence from trade partnerships

• Date: 01 July 2018
• Author: Mustapha Ibn Boamah
• DOI: http://doi.org/10.1016/j.rfe.2017.10.002
• Published date: 01 July 2018

ORIGINAL ARTICLE

Real interest parity: Evidence from trade partnerships

Mustapha Ibn Boamah

Faculty of Business, University of New

Brunswick, New Brunswick, Canada

Correspondence

Mustapha Ibn Boamah, Faculty of

Business, University of New Brunswick,

New Brunswick, Canada.

Email: mboamah@unb.ca

Abstract

This study investigates real interest parity (RIP) in trade partnerships, and whether

RIP depends on the type of trade partnership, using short term interest rates and

the Consumer Price Index (CPI) obtained from the Organization for Economic

Cooperation and Development (OECD) database between 1975 and 2016. The

investigation employs unit root and stationarity tests on interest rate differentials

to study RIP between countries using Germany, United States, and Japan as base

countries for selected countries in the European Union (EU), member countries of

the North American Free Trade Agreement (NAFTA) and selected Asian coun-

tries respectively. The results show evidence in favor of RIP in the selected EU

countries. The interest rate differentials of Belgium, France, Italy, Spain and the

UK with respect to Germany confirms a long-run relationship and real interest

rate parity. There is also evidence to support the RIP in the other trade partner-

ships. With the exception of Mexico, the interest rate differentials for all the

countries are stationary, and each quickly reverts to its mean.

JEL CLASSIFICATION

C22, F15, F36

KEYWORDS

Real interest parity, Real interest rate differential, Stationarity tests, Trade blocs

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INTRODUCTION

The growth in international trade and financial liberalization has brought countries closer and increased international finan-

cial integration. Real interest parity condition equates expected real interest rate differences to expected changes in real

exchange rates. If purchasing power parity is expected to hold, meaning economic agents make their forecasts using

rational expectations and arbitrage forces in a trade bloc are free to act in the goods and assets markets, and no real

exchange rate change is anticipated, then real interest rates in all countries are expected to be ident ical.

A confirmation or rejection of the real interest rate parity is a test of the degree of market integration between countries.

The real interest rate parity (RIP) as a measure of international integration in the goods and assets market is based on

apparent frictionless markets. With increasing volume of international trade and liberalization of domestic financial systems

in Europe, North America and Asia, goods and capital markets are expected to rapidly integrate among trading partners.

Integration of markets tends to limit the ability of central banks to use real interest rates to regulate domestic economic

activity.

This paper approaches the issue by employing unit root and stationarity tests on interest rate differentials to investigate

RIP among countries in two free trade blocs, the EU, NAFTA and two trade partnerships in Asia. It is expected that the

First published online by Elsevier on behalf of The University of New Orleans, 6 October, 2017, https://doi.org/10.1016/j.rfe.2017.10.002

Received: 24 April 2017

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Revised: 5 September 2017

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Accepted: 4 October 2017

DOI: 10.1016/j.rfe.2017.10.002

Rev Financ Econ. 2018;36:199–205. wileyonlinelibrary.com/journal/rfe ©2017 The University of New Orleans

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