The links between international parity conditions and Granger causality: a study of exchange rates and prices

This article investigates Granger causality between exchange rates and prices for the US and four of its trading partners: Canada, Germany, Japan and the UK. We emphasize the distinction between direct and indirect Granger causality: exchange rates directly cause prices if movements in exchange rates lead movement in prices, and exchange rates indirectly cause prices if deviations from the Purchasing Power Parity (PPP) condition can help forecast movement in prices. But only by including the interest-rate differential in our error correction model do we obtain results that align with economic theory. The economic theory of PPP suggests that exchange rates and prices are cointegrated, with exchange rates moving proportionally to prices in the long run. In general, we find either direct or indirect feedback mechanisms between exchange rates and prices.