Real Interest Rate Parity
When both UIRP (particularly in its approximation form) and purchasing power parity (PPP) hold, the two parity conditions together reveal a relationship among expected real interest rates, wherein changes in expected real interest rates reflect expected changes in the real exchange rate. This condition is known as real interest rate parity (RIRP) and is related to the international Fisher effect. The following equations demonstrate how to derive the RIRP equation.
where
- represents inflation
If the above conditions hold, then they can be combined and rearranged as the following:
RIRP rests on several assumptions, including efficient markets, no country risk premia, and zero change in the expected real exchange rate. The parity condition suggests that real interest rates will equalize between countries and that capital mobility will result in capital flows that eliminate opportunities for arbitrage. There exists strong evidence that RIRP holds tightly among emerging markets in Asia and also Japan. The half-life period of deviations from RIRP have been examined by researchers and found to be roughly six or seven months, but between two and three months for certain countries. Such variation in the half-lives of deviations may be reflective of differences in the degree of financial integration among the country groups analyzed. RIRP does not hold over short time horizons, but empirical evidence has demonstrated that it generally holds well across long time horizons of five to ten years.
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