Short-Run Disequilibrium and Long-Run Deviations from Purchasing Power Parity

Abstract

Persistent departures from purchasing power parity (PPP) since the demise of the Bretton Woods system have been well documented by many scholars, including Frenkel (1976) Kravis, Heston, and Summers (1982), and Kravis andLipsey (1983, 1987, 1988). Forexample, Kravis, Heston, and Summers found large departures from PPP for thirty-four countries in 1975, that is, some LDC price levels were about one-third the U.S. price level. In addition, Kravis and Lipsey found that most of the cross-country deviations from PPP can be explained by differences in per capita real GDPs. Wealthier countries tend to have relatively higher price levels, after adjusting for exchange rates. The literature on the disequilibrium approach to exchange rates as in Dombusch (1987), and Frenkel and Rodriguez (1982), can explain short-run exchange rate volatility and short-run deviations from PPP. However, these models generate a movement toward PPP in the long run, and, hence, are inconsistent with the stylized facts. Because of this, Lucas (1978) and Stockman (1982, 1987) have developed an equilibrium approach to exchange rates that allows for pennanent departures from PPP. However, the focus of the equilibrium approach has been on the long-run comparative statics solutions to open economy models, with little attention to exchange rate dynamics and the effect, if any, of such dynamics on the long-run equilibrium. A key element in the analysis below is the well-known idea that the equilibrium solution to a model will be altered if transactions take place when the system is temporarily out of equilibrium, provided that: (i)