Globalization, long memory, and real interest rate convergence: a historical perspective

Area of Science:

• Economics
• International Finance
• Econometrics

Background:

• Globalization integrates economies and financial markets, theoretically favoring parity conditions.
• Existing literature often models interest rate parity deviations differently.
• Three distinct globalization waves (1870-1914, 1944-1971, 1989-present) provide unique periods for analysis.

Purpose of the Study:

• To investigate the validity of Real Interest Rate Parity (RIRP) across three historical globalization waves.
• To model deviations from RIRP as a long-term memory process using fractional integration.
• To compare RIRP findings with Uncovered Interest Rate Parity (UIP) and relative Purchasing Power Parity (PPP).

Main Methods:

• Application of fractional integration methods to real interest rate differentials for seven developed countries against the USA.
• Analysis of data spanning three distinct globalization periods.
• Computation of impulse response functions (IRF) and half-life estimates to characterize memory properties.

Main Results:

• Deviations from RIRP are mean-reverting, indicating real interest rate convergence during all three globalization waves.
• Deviations from relative PPP and UIP are not consistently mean-reverting.
• RIRP, relative PPP, and UIP hold simultaneously in only 7 out of 21 country-wave cases; RIRP and UIP hold in 11 cases.

Conclusions:

• Robust evidence supports real interest rate convergence during globalization, primarily driven by UIP rather than relative PPP.
• The findings suggest that financial market integration, as reflected by UIP, plays a more significant role in RIRP than goods market integration (PPP).
• This study provides novel insights into the memory characteristics of parity condition differentials across different globalization eras.