Real Exchange Rate and Real Interest Rate Differential : A Cointegration Approach with Structural Shifts

Long term determinants of the movements in exchange rate have been an active interest area for both theoretical and empirical research. In this paper, we consider the long run relationship between exchange rates, inflation and interest rates. We find evidence that the Purchasing Power Parity does not hold for the USD/INR exchange rate, which is consistent with previous research. We examine the relationship between real exchange rate and real interest rate differential between India and US. We find weak evidence of cointegration between USD/INR real exchange rate, US real interest rate and Indian real interest, and no cointegration between USD/INR real exchange rate and real interest rate differential using standard cointegration tests. To make our analysis robust, we identify important structural breaks in exchange rate and interest rates and introduce structural breaks in our analysis to test the cointegration between real exchange rate and real interest rates. After introducing structural breaks, we find new evidence of a long term equilibrium relationship between real exchange rate and real interest rate differential. The results of our study underscore the significance of monetary factors in predicting exchange rates in the long run as well as the role of structural shifts in long run time series analysis