The Contribution of Growth and Interest Rate Differentials to the Persistence of Real Exchange Rates

Abstract

This paper employs a new methodology for measuring the contribution of growth and interest rate differential to the half-life of deviations from Purchasing Power Parity (PPP). Our method is based on directly comparing the impulse response function of a VAR model, where the real exchange rate is Granger caused by these variables with the impulse response function of a univative ARMA model for the real exchange rate. We show that the impulse response function of the VAR model is not, in general, the same with the impulse response function obtaianed from the equivalent ARMA representation. If the real exchange rate is Granger caused by other variables in the system. The difference between the two functions captures the effects of the Granger-causing variables on the half-life of deviations for PPP. Our empirical results for a set of four currencies suggest that real and nominal long term interest rates differentials and real GDP growth differentials account for 22% to 50% of the falf-life of deviations from PPP.