Purchasing Power Parity and Uncovered Interest Parity Revisited : Evidence From G7 Exchange Rates Using a Dynamic Joint Model

This paper investigates purchasing power parity (PPP) between the G7 member countries after the advent of the Euro currency. A dynamic joint model of PPP and uncovered interest parity (UIP) is introduced to decompose the real exchange rate (RER) into two components. Interest rate differential (IRD) is found to drive long run dynamics of the RERs. Analysis on evolution of price convergence reveals that the UK parities with the Euro zone countries is steadily strengthened whereas the parities with Japan undergo the most fragile process of price convergence. Impacts of economic and monetary policy uncertainties are found to be significant on the RER. A structural VAR on the IRD and uncertainty indicators confirms that deviations from PPP are caused by the IRD and uncertainty