Real Interest Parity in New Europe

In this paper we investigate the real interest parity condition in ten Eastern European transition countries during 1997-2009 period. Our sample is interesting for three reasons: It covers the second stage of economic transition in the aftermath of the collapse of socialism; the establishment of Euroland at the turn of the century: and enlargement of Euroland to include the Eastern European countries of Slovenia and Slovakia. The data enables us to investigate how the introduction of market mechanisms in the early nineties and the establishment and enlargement of Euroland acted on real interest rate convergence. We test the real interest parity condition with unit root test with and without structural breaks. Inflationary expectations are estimated in two ways: (i) under assumption of rational expectations with ex-post inflation rates and (ii) with ex-ante estimated inflation expectation using ARIMA/ARCH model. Preliminary results suggest that there is a strong evidence of stationarity and relatively weaker evidence of structural breaks.