PPP Strikes Back: Aggregation and the Real Exchange Rate
Posted: 29 Apr 2005
We show the importance of a dynamic aggregation bias in accounting for the PPP puzzle. We prove that the aggregate real exchange rate is persistent because its components have heterogeneous dynamics, that established time series and panel methods fail to control for. When heterogeneity is taken into account, the estimated persistence of real exchange rates falls dramatically. Its half-life, for instance, falls to around one year, significantly below Rogoff's 'consensus view' of three to five years. We show that corrected estimates are consistent with plausible nominal rigidities, thus, arguably, solving the PPP puzzle.
Keywords: Real Exchange Rate Persistence, Purchasing Power Parity, Parameter Heterogeneity
JEL Classification: F36, F41, C43
Suggested Citation: Suggested Citation