PPP Strikes Back: Aggregation and the Real Exchange Rate
April 1, 2003
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Summary
We show the importance of a dynamic aggregation bias in accounting for the PPP puzzle. We prove that established time-series and panel methods substantially exaggerate the persistence of real exchange rates because of heterogeneity in the dynamics of disaggregated relative prices. When heterogeneity is properly taken into account, estimates of the real exchange rate half-life fall dramatically, to little more than one year, or significantly below Rogoff's "consensus view" of three to five years. We show that corrected estimates are consistent with plausible nominal rigidities, thus, arguably, solving the PPP puzzle.
Subject: Econometric analysis, Estimation techniques, Exchange rates, Foreign exchange, Price indexes, Prices, Purchasing power parity, Real exchange rates
Keywords: aggregation, Arellano-Bond estimator, estimation procedure, Estimation techniques, Europe, exchange rate, Exchange rates, goods price, half-life estimate, least squares, mean reversion, OLS estimate, OLS estimator, panel estimation, parameter heterogeneity, Price indexes, purchasing power parity, Real exchange rate persistence, Real exchange rates, reversion increase, time series, traded goods, WP
Pages:
42
Volume:
2003
DOI:
Issue:
068
Series:
Working Paper No. 2003/068
Stock No:
WPIEA0682003
ISBN:
9781451849011
ISSN:
1018-5941
