The Adjustment of Prices and the Adjustment of the Exchange Rate

44 Pages Posted: 18 Oct 2001 Last revised: 17 Jan 2002

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

James Morley

University of Sydney

Date Written: October 2001

Abstract

The purchasing power parity puzzle relates to the adjustment of real exchange rates. Real exchange rates are extremely volatile, suggesting that temporary shocks emanate from the monetary sector. But the half-life of real exchange rate deviations is extremely large -- 2.5 to 5 years. This half-life seems too large to be explained by the slow adjustment of nominal prices. We offer a different interpretation. We maintain that nominal exchange rates and prices need not converge at the same rate, as is implicit in rational-expectations sticky-price models of the exchange rate. Evidence from an unobserved components model for nominal prices and nominal exchange rates that imposes relative purchasing power parity in the long run indicates that nominal exchange rates converge much more slowly than nominal prices. The real puzzle is why nominal exchange rates converge so slowly.

Suggested Citation

Engel, Charles M. and Morley, James, The Adjustment of Prices and the Adjustment of the Exchange Rate (October 2001). NBER Working Paper No. w8550. Available at SSRN: https://ssrn.com/abstract=287747

Charles M. Engel (Contact Author)

University of Wisconsin - Madison - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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University of Washington - Department of Economics ( email )

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James Morley

University of Sydney ( email )

Rm 370 Merewether (H04)
Sydney, NSW 2006 2008
Australia

HOME PAGE: http://https://sites.google.com/site/jamescmorley/

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