Real Exchange Rate and Real Interest Differential in UK

The study analyses the relationship between real exchange rate and real interest differential in pre and post inflation targeting regime (ITR). Under inflation targeting regime, the key instruments is the interest rate, which has been more volatile in the post ITR period and so has been the money supply. However, UK has been quite successful in controlling the main target variable, inflation. A constant trend is observed in real money differential in the post ITR period with the implication that inflation might be controlled with a constant change in money supply each year. It has been found that in pre ITR the long run relationship between the real exchange rate, the real interest differential, and the real money differential exist but in the post ITR period it does not. Moreover, in the post ITR period, the long run relationship between the real exchange rate and the real interest differential exist except for UK-USA. Though theories of sticky prices show negative association between the real exchange rate and the real interest differential but in the present study in the post ITR period it comes out to be positive.