Real Interest Parity in New Europe

Abstract

In this paper we investigate the real interest parity condition in ten Eastern European transition countries during 1997-2009. Our sample is interesting because it covers important periods or events: the second stage of economic transition in the aftermath of the collapse of socialism; the establishment of the eurozone at the turn of the century; and the enlargement of the eurozone to include the Eastern European countries of Slovenia and Slovakia. The data enable us to investigate how the introduction of market mechanisms in the early 1990s and the establishment and enlargement of the eurozone acted on real interest rate convergence. We test the real interest parity condition using a unit root test with and without structural breaks. Inflationary expectations are estimated in two ways: (1) under assumption of rational expectations with ex post inflation rates, and (2) with ex ante adaptive inflation expectation modeled using an ARIMA/ARC H model. Results suggest that there is strong evidence of stationarity and relatively weaker evidence of structural breaks, particularly when using adaptive inflation expectations.