Working Paper no. 50

International Parity Relationships Between Germany And The United States: A Joint Modelling Approach

Katarina Juselius And Ronald Macdonald

Abstract.
This paper examines the determination of US and German inflation rates, short- and long-term interest rates, and real exchange rates over the period 1975–1998. The empirical mechanisms behind the adjustment towards purchasing power parity in the goods market and uncovered interest parity in the capital market are examined, as well as the interconnections between the two. The dynamics of the adjustment underlying the term structure of interest rates and the Fisher real interest rate parity within and between the two countries turns out to be of crucial importance for a full understanding of the complicated interrelationships between the USA and Europe. The empirical model is based on the cointegrated VAR, which allows us to test and estimate short- and long-term effects, the dynamics of the adjustment process and interactions and feed-back effects. The dynamics of the structure are shown to be remarkably stable. Since our sample period covers many fundamental changes in the world economy, we believe this refutes the Lucas’ critique. An important finding is that the very slow, though significant, price adjustment towards sustainable levels of real exchange rates, has been compensated by corresponding changes in the spread of the long-term bond rates. Related to this is the strong empirical support for the weak exogeneity of the long-term bond rates, signifying the importance of the large US trade deficits (i.e. the low levels of US savings) and, hence, their linkage to international finance. Altogether, the results suggest that the actual transmission mechanisms over the post Bretton Woods period have been significantly different from standard theoretical assumptions.

Ronald MacDonald, MacDonald is Professor of International Macroeconomics at University of Strathclyde. MacDonald co-directs two GEI projects "Unexplained Relationships in Three Regimes of the International Monetary System" and "Optimal International Regimes and global Economic Institutions". Contact: Department of Economics, University of Strathclyde, Glasgow, G4 0LN, UK, tel: (44 141) 548 3861. r.r.macdonald@strath.ac.uk

Katarina Juselius, Institute of Economics, University of Copenhagen