Modelling the US/UK real exchange rate-real interest rate differential relation: A multivariate regime switching approach

This paper investigates the empirical link between the US/UK real exchange rate and real interest differential for the period 1959-2002, using a bivariate Markov switching vector autoregression model. We find strong evidence of volatility regime switching in the US/UK real exchange rate-real interest differential relation. There is also evidence of a regime-dependent dynamic link. These findings indicate that allowing for multivariate regime switching can reconcile theoretical models of exchange rates which predict a strong link between real exchange rates and the real interest differential, and previous empirical evidence which failed to uncover such a link. © Blackwell Publishing Ltd and The University of Manchester, 2005.