Real or monetary? The US/UK real exchange rate, 1921-2002

This paper investigates the empirical link between the real exchange rate and the real interest differential, and the real exchange rate and the real output differential for the UK and the US. We use an extended set of monthly data for the period 1921-2002, which ensures high power of statistical tests, and a vector autoregression which allows for regime switches. In contrast to previous studies, we find evidence of both, a dynamic and a contemporaneous link between real exchange rate changes and the real interest rate differential. The real output differential is not linked with real exchange rate changes. The response of the real exchange rate to real interest differential shocks is much more persistent than its response to a real output differential shock. The results suggest that the real interest rate differential should receive further attention in building real exchange rate models.