Question

Why is the real interest parity condition more likely to hold true over long time periods that over short time periods?

Answer 1

Before we get into this question, let's quickly understand what Real Interest Parity Condition (referred to as "RIPC" in the remainder of my answer) means.

While there are many definitions and version of RIPC, it has two key meanings in the simplest of the language:

1. Real interest rate across the countries should be same and equal
2. Real rate of return on identical assets should be same across the countries

While numerous articles and papers have been written over RIPC, empirical evidences show that RIPC is very unlikely to hold true in short run. In real life also, we see unequal real interest rates across countries. We also notice same asset giving different real returns in different countries. Reasons why RIPC may not hold true over short time periods are many:

1. Countries have different level of specific risks. USA is perceived to be safer investment destination than say China. A democratic government may be considered safer than a communist government in China. A two party democracy (in USA) is considered safer than multi party democracy elsewhere (say in India). Pakistan and Afghanistan are prone to terrorism risks. So, different countries have different levels of perceived risk. Hence, the real rate of return or real interest rates in different countries will vary in short time period.
2. Different countries have different transaction costs on trades.
3. The indirect taxation structure, tax rates, tax slabs are different across geographies.
4. Different countries have different liquidity issues and hence liquidity risks. A country with deeper and broader stock exchange markets will have lower liquidity risk than a country with narrow and shallow stock exchange market. So the same assets traded in the capital markets of the two countries will have different expected real returns.
5. Information asymmetry across countries is another factor.
6. For the RIPC to hold true in short run, all other parity conditions need to be true in short run:
   1. Purchasing power parity ("PPP")
   2. Uncovered interest parity
   3. Fisher's equation

7. Empirical studies and evidences support that PPP may be more likely to hold ture in the long run. In order to provide explanation, we will have to understand the assumptions leading to PPP and check whether those assumptions are valid more in long run or short run:

   1. One assumption in PPP is that prices of goods and services are predominant driver of exchange rate. In reality, there are many other factors like interest rate, costs, political stability, economic stability, etc that also impact the exchange rate. In the short run these factors may dominate over the effect of inflation captured in the cost of goods and services and hence exchange rate may deviate from PPP. In the long run, these other factors usually don't dominate the impact of inflation on exchange rate. hence deviation from PPP in the long run is lower.
   2. Another assumption in PPP is that law of one price holds true. Studies have shown that law of one price appears to hold true in long run but not in short run.

However in the long run, most of the variables we have talked about tend to normalize. PPP as well as inflation rates do stabilize. The economy achieves maturity and stability in the long run with respect to inflation, interest rates and exchange rates. It's not that deviations had not been seen in the long run. However deviations from PPP as RIPC had been lower in long run than in shorter period of time. Therefore, theoretically, the real interest parity condition is more likely to hold true over long time periods that over short time periods. But the question that needs to be answered is "how long away is the long run?" What is a long run and when will it arrive.