Exchange Rate Economics: Theories and Evidence

Real exchange rate determination 205
the kind of variables highlighted by the model presented in this section to model
long- and short-run real and nominal exchange rates.
8.2 Empirical tests of real exchange rate models
8.2.1 Real interest rate parity
In order to examine the systematic components of real exchange rates,a number
of researchers have focused on just one of the relationships of the model presented
in the last section,namely the uncovered interest parity condition (8.5),expressed
here in real terms,by subtracting the expected inflation differential from both the
expected change in the exchange rate and the interest differential and setting the
risk premium to zero:
E t (q t+k − q t ) = ( k r t − k rt ∗ ). (8.15)
In expressing (8.15) in a form suitable for econometric testing most researchers
follow Meese and Rogoff (1984) and assume the following adjustment equation for
the real exchange rate:
E t (q t+k −¯q t+k ) = θ k (q t −¯q t ),
0