Research Discussion Paper – RDP 9111 Monthly Movements in the Australian Dollar and Real Short-term Interest Differentials: An Application of the Kalman Filter
November 1991
Abstract
This paper applies a rational expectations model of the real exchange rate to Australian data. Specifically, it decomposes monthly movements in Australia's real exchange rate into a transitory and a permanent component. The transitory component is identified with changes in the unobservable ex ante short-term real interest differential. The permanent component is denoted as changes in the unobservable long-run equilibrium real exchange rate. A state space model provides the framework for the treatment of these unobservable components and the traditional assumptions of the expectations hypothesis of the term structure of interest rates and no cross-currency risk premium are relaxed.
The ex ante real interest differential is found to explain very little of the month-to-month movement in the real exchange rate. However, given that the Australian data fails to unambiguously support the existence of a risk premium in the foreign exchange market, the model collapses to an uncovered interest parity relation which finds little empirical support in the literature. These results imply that the model's assumption of rational expectations and hence, an efficient market in foreign exchange, may be inappropriate for describing the monthly variation in Australia's real exchange rate.