The real exchange rate-real interest rate relation: evidence from tests for symmetric and asymmetric threshold cointegration

This paper investigates the existence of threshold cointegration between real exchange rates and real interest rate differentials. Unlike previous work, which generally fails to find evidence of a long-run relationship employing linear models, we employ tests of the null hypothesis of no cointegration derived from nonlinear bivariate models that allow for threshold cointegration under the alternative hypothesis. For six of the countries in our sample our analysis reveals some evidence of a nonlinear long-run relationship between real exchange rates and real interest rate differentials. Asymmetric mean reversion of the equilibrium error is found to be driven by the asymmetric short-run adjustment of the real exchange rate to dis-equilibrium. When threshold cointegration is found to exist, we find stronger mean reversion when the equilibrium error is negative relative to when it is positive. Copyright © 2006 John Wiley & Sons, Ltd.