Understanding the PPP Puzzle: The Dynamics of Real Exchange Rates Towards Their Time-Varying Equilibrium

28 Pages Posted: 12 Oct 2015 Last revised: 20 Sep 2017

See all articles by Shifu Jiang

Shifu Jiang

University of Surrey

Gabriel Talmain

University of York - Department of Economics and Related Studies

Date Written: January 4, 2016

Abstract

We model the real exchange rates between the US and 18 OECD countries by an innovative dynamic process called integral correction mechanism, and allow a real exchange rate equilibrium determined by Harrod-Balassa-Samuelson effects. The Harrod-Balassa-Samuelson effect works through a direct channel and a terms of trade channel. We find that the terms of trade channel is significant in more countries than the direct channel. Using a popular smooth transition autoregression model as a benchmark, we find that our model often statistically outperforms the benchmark. And the origin of this superiority is that our model captures autocorrelation functions of the real exchange rates very well. Our model features that the real exchange rate reverts to its equilibrium very quickly in the short run but moves back and forth around the equilibrium in the long run. These particular dynamics help us understand Rogoff's PPP puzzle and forecast the real exchange rate.

Keywords: Real Exchange Rate, Harrod-Balassa-Samuelson Effect, Integral Correction Mechanism, Smooth Transition Autoregression

Suggested Citation

Jiang, Shifu and Talmain, Gabriel, Understanding the PPP Puzzle: The Dynamics of Real Exchange Rates Towards Their Time-Varying Equilibrium (January 4, 2016). Available at SSRN: https://ssrn.com/abstract=2672402 or http://dx.doi.org/10.2139/ssrn.2672402

Shifu Jiang (Contact Author)

University of Surrey ( email )

Guildford
Guildford, Surrey GU2 5XH
United Kingdom

Gabriel Talmain

University of York - Department of Economics and Related Studies ( email )

Heslington
York, YO1 5DD
United Kingdom

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