A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings
39 Pages Posted: 15 Dec 2008
Date Written: December 8, 2008
Asset prices undergo long swings that revolve around benchmark levels. In currency markets, fluctuations involve real exchange rates that are highly persistent and that move in near-parallel fashion with nominal rates. The inability to explain these two regularities with one model has been called the "Purchasing Power Parity puzzle". In this paper, we trace the puzzle to exchange rate modelers' use of the "Rational Expectations Hypothesis". We show that once imperfect knowledge is recognized, a monetary model is able to account for the puzzle, as well as other salient features of the data, including the long-swings behavior of exchange rates.
Keywords: PPP puzzle, Long Swings, Imperfect Knowledge, Rational Expectations
JEL Classification: F31, F41, G15, G17
Suggested Citation: Suggested Citation