A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings

42 Pages Posted: 15 Jan 2009

See all articles by Roman Frydman

Roman Frydman

New York University (NYU) - Department of Economics

Michael D. Goldberg

University of New Hampshire

Soren Johansen

University of Copenhagen - Department of Economics; Aarhus University - CREATES

Katarina Juselius

University of Copenhagen - Department of Economics

Date Written: January 12, 2009

Abstract

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

Frydman, Roman and Goldberg, Michael D. and Johansen, Soren and Juselius, Katarina, A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings (January 12, 2009). Available at SSRN: https://ssrn.com/abstract=1326396 or http://dx.doi.org/10.2139/ssrn.1326396

Roman Frydman (Contact Author)

New York University (NYU) - Department of Economics ( email )

19 West 4th Street
New York, NY 10012
United States

Michael D. Goldberg

University of New Hampshire ( email )

Durham, NH 03824
United States
603-862-3385 (Phone)
603-862-3383 (Fax)

HOME PAGE: http://pubpages.unh.edu/~michaelg/

Soren Johansen

University of Copenhagen - Department of Economics ( email )

Øster Farimagsgade 5
Bygning 26
1353 Copenhagen K.
Denmark

Aarhus University - CREATES ( email )

Nordre Ringgade 1
Aarhus, DK-8000
Denmark

Katarina Juselius

University of Copenhagen - Department of Economics ( email )

Øster Farimagsgade 5
Bygning 26
1353 Copenhagen K.
Denmark

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