Exchange rates and prices: revisiting Granger causality tests

Abstract

This paper examines whether causal relationships exist between exchange rates and prices for the United States and its trading partners: Canada, Germany, Japan, and the United Kingdom. Our empirical methods of focus do not impose the controversial purchasing power parity (PPP) assumption, yet we find that imposing PPP via an error correction system largely confirms our other findings. Our results suggest that exchange rates have Granger caused wholesale prices for all four U.S. trading partners, and there is considerable evidence that the opposite is true for Canada and Japan. In general, we find no causal relationships between consumer prices and exchange rates. Because Granger (non)causality may be due to omitted variables, we discuss this issue in the context of exchange rates and prices.

Keywords:

• Granger causality
• model selection
• purchasing power parity