REAL INTEREST-RATE EQUALIZATION AND THE INTEGRATION OF INTERNATIONAL FINANCIAL-MARKETS

This paper argues that conventional regression tests of real interest rate equality may be misleading because they neglect to consider transactions costs. A transactions cost band may inhibit the one-to-one correspondence between changes in real rates in alternative countries that is presumed by conventional tests. Statistical problems which may lead to incorrect inferences in conventional tests are also discussed. Alternative tests which overcome these limitations are developed and applied to real interest rates for ten different countries. The alternative tests generate much stronger support for interest parity than is found in the existing literature. (JEL F36).