Are Real Interest Differentials Caused by Frictions in Goods or Assets Markets, Real or Nominal Shocks?

The variance of real interest rate differentials (rids) is decomposed between ex post deviations from relative purchasing power parity and uncovered interest rate parity (UIRP) for a set of emerging markets from 1995M5 to 2004M3. The results point out to nominal interest rate differentials and ex post deviations from UIRP as the main source of volatility in rids. In order to uncover the dynamic effects of real and monetary disturbances, I estimated a bivariate VAR with rids and nominal interest rate differentials. Forecast error variance decomposition using short run restrictions on the VAR strongly supports the claim that money shocks are unable to explain the variability of rids at longer horizons. Long-run restrictions results in real shocks as the likely cause of rids. Analysis of impulse response functions demonstrates that the net impact of a (one standard deviation) real shock on rids after 36 months is large.