The evolution of purchasing power parity

Abstract

A large body of literature in international finance has attempted to estimate the speed of convergence between countries’ aggregate price indices to those levels predicted by purchasing power parity (PPP). This paper takes a novel approach by considering how this speed of convergence itself has evolved over time. Using a dynamic common correlated effects (DCCE) framework from Chudik and Pesaran (2015) applied to a panel of countries’ real exchange rates over the years 1960–2015, we find an average half-life of around 3 years. Moreover, we show that the estimated half-life fell by about 2 years over the course of the past five decades, suggesting that the so-called PPP puzzle (Rogoff, 1996) may abating over time. Our results also serve to contextualize past estimates by demonstrating a high degree of sample selection sensitivity in this literature. Furthermore, we propose explanations for the observed increase in the speed of international price adjustments, focusing primarily on the increasingly tradable nature of the composition of the U.S. consumer price index (CPI). We build a measure of tradability of the CPI and show that, despite an increase in the proportion of services in the average consumer’s basket, the CPI has become more tradable over time, thus offering a potential explanation for the observed increase in adjustment speed.