Parity Reversion in Real Exchange Rates: Fast, Slow or Not At All?
IMF Working Papers, July 1, 2004
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Bibliographic details
- Authors: C. John McDermott, Paul Cashin
- Published: July 1, 2004
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451855074.001
Key Findings
- Consensus estimates put the half-life of deviations from purchasing power parity (PPP) at about four years (Rogoff, 1996).
- Conventional least squares estimates of half-lives are biased downward.
- Using median-unbiased estimators of the half-life of deviations from parity corrects for the downward bias of conventional estimators.
- Tests for PPP using real effective exchange rate data for 90 developed and developing countries in the post-Bretton Woods period find support for PPP: the majority of countries experience finite deviations of real exchange rates from parity.
- The speed of parity reversion is typically much faster for developed countries than for developing countries.
- Parity reversion is considerably faster for countries with flexible nominal exchange rate regimes compared with countries having fixed nominal exchange rate regimes.
Methodology and Data
- Preferred persistence measure: median-unbiased estimators of the half-life of deviations from parity (to correct downward bias of conventional estimators).
- Data: real effective exchange rate data for 90 developed and developing countries.
- Sample period: post-Bretton Woods period.
- Tests employed to evaluate PPP and parity reversion across countries and exchange rate regimes.
Analytical Insights
- Estimation bias:
- Conventional least squares methods produce downward-biased half-life estimates.
- Median-unbiased estimation provides a more reliable measure of persistence for real exchange rate shocks.
- Heterogeneity:
- Developed vs developing countries: developed countries show typically much faster parity reversion.
- Exchange rate regimes: flexible nominal exchange rate regimes exhibit considerably faster parity reversion than fixed regimes.
- Empirical support:
- Majority of the 90 countries analyzed display finite deviations from parity, consistent with PPP reversion over time.
Implications
- Empirical practice:
- Researchers estimating half-lives of PPP deviations should account for downward bias in least squares estimates and consider median-unbiased estimators.
- Policy relevance:
- Exchange rate regime choice (flexible vs fixed) is associated with differences in the speed of real exchange rate adjustment; policymakers should consider these dynamics when assessing external competitiveness and adjustment needs.
- Country heterogeneity:
- Distinctions between developed and developing countries matter for expected speed of reversion and should inform macroeconomic modeling and policy design.