A new interpretation of the exchange rate–yield differential nexus

Empirical studies have had difficulty in establishing the long‐run relationship between real exchange rates and real yield differentials predicted by sticky price exchange rate models. We revisit this issue in a nonstationary panel regression framework. This facilitates estimation of a long‐run parameter even when the underlying relation‐ship is subject to permanent shocks or the variables do not cointegrate. The slope coefficient estimate from a sample of 23 industrialized countries 1973M1–1998M12 has the correct sign and is statistically significant for both short and long‐term yields. These results support fundamentals‐based models of exchange rate behaviour while permitting real factors to play a role. Moreover, they indicate that capital markets integration is more advanced than hitherto believed.