Inflation-targeting and real interest rate parity: A bias correction approach

- We investigate whether inflation-targeting affects real interest rate parity.
- A bias correction method with cross-sectional dependence is employed.
- Implicit deflators for durable goods' and service consumptions are employed.
- Inflation-targeting yields strong mean reversion and a tight confidence interval.
- Inflation-targeting plays an important role for long-run RIP.

This paper investigates whether inflation-targeting influences real interest rate parity (RIP) by a bias correction approach under cross-sectional dependence. The recursive mean adjustment (RMA) method proposed by So and Shin (1999) and Shin and So (2001) is employed to correct the downward bias in the panel unit root tests and in the half-life estimates of real interest rate differentials for traded and non-traded goods. The empirical findings differ depending on whether we apply the RMA. More importantly, the empirical results show that as more homogeneous economies become involved in terms of inflation-targeting regime, stronger mean reversion and much a tighter confidence interval are present. Thus, inflation-targeting plays an important role in providing favorable evidence for long-run RIP.