Aggregation and the PPP Puzzle in a Sticky-Price Model

49 Pages Posted: 9 Nov 2008 Last revised: 21 Sep 2010

See all articles by Carlos Carvalho

Carlos Carvalho

Government of the Federative Republic of Brazil - Central Bank of Brazil; Pontifical Catholic University of Rio de Janeiro (PUC-Rio) - Department of Economics

Fernanda Nechio

Federal Reserve Banks - Federal Reserve Bank of San Francisco

Multiple version iconThere are 3 versions of this paper

Date Written: August 31, 2010

Abstract

We study the purchasing power parity (PPP) puzzle in a multi-sector, two-country, sticky-price model. Across sectors, firms differ in the extent of price stickiness, in accordance with recent microeconomic evidence on price setting in various countries. Combined with local currency pricing, this leads sectoral real exchange rates to have heterogeneous dynamics. We show analytically that in this economy, deviations of the real exchange rate from PPP are more volatile and persistent than in a counterfactual one-sector world economy that features the same average frequency of price changes, and is otherwise identical to the multi-sector world economy. When simulated with a sectoral distribution of price stickiness that matches the microeconomic evidence for the U.S. economy, the model produces a half-life of deviations from PPP of 39 months. In contrast, the half-life of such deviations in the counterfactual one-sector economy is only slightly above one year. As a by-product, our model provides a decomposition of this difference in persistence that allows a structural interpretation of the different approaches found in the empirical literature on aggregation and the real exchange rate. In particular, we reconcile the apparently conflicting findings that gave rise to the "PPP Strikes Back debate" (Imbs et al. 2005a,b and Chen and Engel 2005).

Keywords: heterogeneity, aggregation, price stickiness, real exchange rates, PPP puzzle

JEL Classification: F30, F41, E00

Suggested Citation

Carvalho, Carlos and Nechio, Fernanda, Aggregation and the PPP Puzzle in a Sticky-Price Model (August 31, 2010). Available at SSRN: https://ssrn.com/abstract=1298146 or http://dx.doi.org/10.2139/ssrn.1298146

Carlos Carvalho (Contact Author)

Government of the Federative Republic of Brazil - Central Bank of Brazil ( email )

P.O. Box 08670
SBS Quadra 3 Bloco B - Edificio-Sede
Brasilia, Distr. Federal 70074-900
Brazil

Pontifical Catholic University of Rio de Janeiro (PUC-Rio) - Department of Economics ( email )

Rua Marques de Sao Vicente, 225/206F
Rio de Janeiro, RJ 22453
Brazil

HOME PAGE: http://https://sites.google.com/site/cvianac2/carloscarvalho

Fernanda Nechio

Federal Reserve Banks - Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

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