A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings
42 Pages Posted: 15 Jan 2009
Date Written: January 12, 2009
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 hypothesis
JEL Classification: F31, F41, G15
Suggested Citation: Suggested Citation