Stock market information and the relationship between real exchange rate and real interest rates

Abstract

In this paper we propose to augment the traditional relationship between real exchange rates and real interest rates (RERI) by adding the stock market equilibrium condition to it. We introduce the relative dividend yield as the new information variable. In the empirical analysis we use recent monthly observations from the U.K., Japan, Canada and Eurozone, all relative to the U.S. We show that the introduction of stock market information is highly relevant for the functioning of the RERI hypothesis. Based on the results from the cointegration analysis the role of relative stock market performance is especially important in the short- term (3 month) horizon, where the augmented RERI representation is most stronlgy supported.