PPP Strikes Back: Aggregation and the Real Exchange Rate
Jean M. Imbs
Paris School of Economics (PSE); Centre for Economic Policy Research (CEPR); Swiss Finance Institute
University of London - School of Sciences
Morten O. Ravn
European University Institute - Economics Department (ECO); London Business School - Department of Economics; University of Southampton; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
London Business School; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
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.
Number of Pages in PDF File: 55
Keywords: Real Exchange Rate Persistence, Purchasing Power Parity, Aggregation, Parameter Heterogeneity
JEL Classification: F36, F41, C43
Date posted: March 13, 2003
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