Quantifying the Half-Life of Deviations from PPP: The Role of Economic Priors

35 Pages Posted: 25 Jan 2015

See all articles by Lutz Kilian

Lutz Kilian

University of Michigan at Ann Arbor - Department of Economics; Centre for Economic Policy Research (CEPR)

Tao A. Zha

Federal Reserve Bank of Atlanta

Date Written: December 1999

Abstract

The half-life of deviations from purchasing power parity (PPP) plays a central role in the ongoing debate about the ability of macroeconomic models to account for the time series behavior of the real exchange rate. The main contribution of this paper is a general framework in which alternative priors for the half-life of deviations from PPP can be examined. We show how to incorporate formally the prior views of economists about the half-life. In our empirical analysis we provide two examples of such priors. One example is a consensus prior consistent with widely held views among economists with a professional interest in the PPP debate. The other example is a relatively diffuse prior designed to capture a large degree of uncertainty about the half-life. Our methodology allows us to make explicit probability statements about the half-life and to assess the likelihood that the half-life exceeds a given number of years, without taking a stand on whether or not the data have a unit root. We find only very limited support for the common view in the PPP literature that the half-life is between three and five years.

Keywords: purchasing power parity, half-life, mean reversion, persistence, likelihood

JEL Classification: F41, C11

Suggested Citation

Kilian, Lutz and Zha, Tao A., Quantifying the Half-Life of Deviations from PPP: The Role of Economic Priors (December 1999). FRB Atlanta Working Paper Series No. 99-21. Available at SSRN: https://ssrn.com/abstract=2491279 or http://dx.doi.org/10.2139/ssrn.2491279

Lutz Kilian

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States
734-764-2320 (Phone)
734-764-2769 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Tao A. Zha (Contact Author)

Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States
404-521-8353 (Phone)
404-521-8956 (Fax)

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