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

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