Purchasing Power Parity Puzzle Research Articles

Do Panels Help Solve the Purchasing Power Parity Puzzle?

Although Rogoff described the “remarkable consensus” of 3- to 5-year half-lives of purchasing power parity (PPP) deviations among studies using long-horizon data, recent works using panel methods with post-1973 data report shorter half-lives of 2 to 2.5 years. But these studies do not use appropriate techniques to measure persistence. We extend median-unbiased estimation methods to the panel context, calculate both point estimates and confidence intervals, and provide strong evidence confirming Rogoff's original claim. Although panel regressions provide more information on the persistence of real exchange rate shocks than univariate regressions, they do not help solve the PPP puzzle.

Viewpoint: Towards a solution to the puzzles in exchange rate economics: where do we stand?

Abstract. This paper provides a selective overview of puzzles in exchange rate economics. We begin with the forward bias puzzle: high interest rate currencies appreciate when one might guess that investors would demand higher interest rates on currencies expected to fall in value. We then analyse the purchasing power parity puzzle: the real exchange rate displays no (strong) reversion to a stable long‐run equilibrium level. Finally, we cover the exchange rate disconnect puzzle: the lack of a link between the nominal exchange rate and economic fundamentals. For each puzzle, we critically review the literature and speculate on potential solutions. JEL classification: F31

DOES ‘AGGREGATION BIAS’ EXPLAIN THE PPP PUZZLE?

Abstract. Recently, Jean Imbs and colleagues have claimed that much of the purchasing power parity puzzle can be explained by ‘aggregation bias’. This paper re‐examines aggregation bias. It clarifies the meaning of aggregation bias and its applicability to the PPP puzzle; demonstrates that the size of the ‘bias’ is much smaller than suggested if explosive roots in the simulations are ruled out; and shows that the presence of non‐persistent measurement error data can make price series appear less persistent than they are. After correcting for small‐sample bias, half‐life estimates indicate that heterogeneity and aggregation bias do not help to solve the PPP puzzle.

Nonlinear Purchasing Power Parity under the Gold Standard

1. IntroductionRecent theoretical analysis of purchasing power deviations (see, e.g., Dumas 1992; Sercu, Uppal, and Van Hull 1995; and O'Connell and Wei 1997) demonstrates how transactions costs or the sunk costs of international arbitrage induce nonlinear adjustment of the real exchange rate to purchasing power parity (PPP). Globally mean-reverting this nonlinear process has the important property of exhibiting near unit root behavior for small deviations from PPP since small deviations from PPP are left uncorrected if they are not large enough to cover the transactions costs or the sunk costs of international arbitrage.A parametric nonlinear model, suggested by the theoretical literature, that captures the nonlinear adjustment process in aggregate data is the exponential smooth transition autoregression model (ESTAR) of Ozaki (1985). A smooth, rather than discrete, adjustment mechanism is motivated by the theoretical analysis of Dumas (1992). Also, as postulated by Terasvirta (1994) and demonstrated theoretically by Berka (2002), in aggregate data regime changes may be smooth, rather than discrete, given that heterogeneous agents do not act simultaneously even if they make dichotomous decisions.1 Recent empirical work (e.g., Michael, Nobay, and Peel 1997; Taylor, Peel, and Sarno 2001; Peel and Venetis 2002) has reported empirical results that suggest that the ESTAR model provides a parsimonious fit into a variety of data sets, particular for monthly data for the interwar and postwar floating period as well as for annual data spanning 200 years, as reported in Lothian and Taylor (1996). In addition, nonlinear impulse response functions derived from the ESTAR models show that although the speed of adjustment for small shocks around equilibrium will be highly persistent, larger shocks mean-revert much faster than the glacial rates previously reported for linear models (Rogoff 1996). In this respect, the ESTAR models provide some solution to the PPP puzzle outlined in Rogoff (1996).2The ESTAR model can also provide an explanation of why PPP deviations analyzed from a linear perspective appear to be described by either a nonstationary integrated I(1) process, or alternatively, described by fractional processes (see, e.g., Diebold, Husted, and Rush 1991). Taylor, Peel, and Sarno (2001), and Pippenger and Goering (1993) show that the Dickey-Fuller tests have low power against data simulated from an ESTAR model. Michael, Nobay, and Peel (1997) and Byers and Peel (2003) show that data that is generated from an ESTAR process can appear to exhibit the fractional property. That this would be the case was an early conjecture by Acosta and Granger (1995). Given that the ESTAR model has a theoretical rationale, whereas the fractional process is a relatively nonintuitive one, the fractional property might reasonably be interpreted as a misleading linear property of PPP deviations (Granger and Terasvirta 1999).Whereas the empirical work employing ESTAR models provides some explanation of the glacially slow adjustment speeds obtained in linear models, there is one aspect of the empirical work that is worthy of further attention. A second way of explaining the Rogoff puzzle, raised by Rogoff himself,3 is to relax the assumption that the equilibrium real exchange rate is a constant (see, e.g., Canzoneri, Cumby, and Diba 1996; and Chinn and Johnston 1996). Theoretical models, such as that of Balassa (1964) and Samuelson (1964), imply a nonconstant equilibrium in the real exchange rate if real productivity growth rates differ between countries.4 Nonlinear models that incorporate proxies for these effects are found to parsimoniously fit post-Bretton Woods data for the main real exchange rates (see Venetis, Paya, and Peel 2002; and Paya, Venetis, and Peel 2003). Naturally, models that ignore this effect may generate misleading speeds of PPP adjustment to shocks. In this regard, the empirical results of Hegwood and Papell (2002) for the Gold Standard period are particularly interesting. …

The purchasing power parity puzzle, temporal aggregation, and half-life estimation

We show, analytically, that ordinary least square (OLS)-based estimates of the half-life in a temporally aggregated AR(1) model suffer from large asymptotic biases. We then demonstrate, via simulations, that accurate estimates of half-lives can be obtained in finite samples using temporally aggregated data.

Sticky Prices and the Purchasing Power Parity Puzzle

This paper investigates the Purchasing Power Parity Puzzle in the context of a Vector Autoregressive(VAR) model, where the real exchange rate is Granger caused by macroeconomic variables, suggested by 'sticky-price' theories of exchange rate determination. By doing this, we are able to discern the relative effect of nominal price rigidities on the speed of adjustment of the real exchange rate towards long-run PPP. We first show that the impulse response function of a variable participating in the VAR is not, in general, the same with the impulse response function obtained from the equivalent ARMA representation of this variable, if the latter is Granger caused by other variables in the system. The difference between the two functions captures the effects of the Granger-causing variables on the dynamic adjustment process of the variable of interest. Our empirical results for a set of four currencies suggest that price stickiness accounts for 22% to 50% of the half-life of innovations in the real exchange rate.

Getting PPP Right: Identifying Mean-Reverting Real Exchange Rates in Panels

Recent advances in testing for the validity of Purchasing Power Parity (PPP) focus on the time series properties of real exchange rates in panel frameworks. One weakness of such tests, however, is that they fail to inform the researcher as to which cross-section units are stationary. As a consequence, a reservation for PPP analyses based on such tests is that a small number of real exchange rates in a given panel may drive the results. In this paper we examine the PPP hypothesis focusing on the stationarity of the real exchange rates in up to 25 OECD countries. We introduce a methodology that when applied to a set of established panel-unit-root tests, allows to identify the real exchange rates that are stationary and poolable without trading-off any test power. We apply procedures that account for cross-sectional dependence. Our results reveal evidence of mean-reversion that is significantly stronger as compared to those obtained by the existing literature, strengthening the case for PPP. Moreover, our approach allows to provide half-lives estimates for the mean-reverting real exchange rates and so find that the half-lives are shorter than the literature consensus and therefore that the PPP puzzle is less pronounced than initially thought.

Commodity currencies

This paper looks at real exchange rate behavior by focusing on three OECD economies (Australia, Canada, and New Zealand) where primary commodities constitute a significant share of their exports. For Australia and New Zealand especially, we find that the US dollar price of their commodity exports (generally exogenous to these small economies) has a strong and stable influence on their floating real rates, with the magnitude of the effects consistent with predictions of standard theoretical models. However, after controlling for commodity price shocks, there is still a purchasing power parity puzzle in the residual. The results here are relevant to developing commodity-exporting countries as they liberalize their capital markets and move towards floating exchange rates.

The purchasing power parity hypothesis for a high inflation country: a re-examination of the case of Turkey

The long-run purchasing power parity (PPP) hypothesis is re-examined for Turkey and strong evidence on long-run PPP is provided by using standard multivariate cointegration techniques. It is argued that the refutation of PPP by Telatar and Kazdagli does not necessarily imply the failure of taking the non-linearity in real exchange rate adjustment into account, as proposed by Sarno, but it may be due to the use of univariate framework for testing PPP chosen by Telatar and Kazdagli. By using persistence profiles, half-life deviations from PPP are estimated as low as one and a half years. Since these estimates are substantially lower than those previously obtained in the literature, the analysis suggests that high inflation environment does not constitute a case for the PPP puzzle.

Why is it so Difficult to Beat the Random Walk Rorecast of Exchange Rates?

We propose an exchange rate model that can explain both the observed volatility and the persistence of real and nominal exchange rate movements and thus in some measure resolves Rogoff's (1996) purchasing power parity puzzle. Our analysis reconciles the well-known difficulties in beating the random walk forecast model with the statistical evidence of nonlinear mean reversion in deviations from fundamentals. Our analysis also provides a compelling rationale for the long-horizon predictability of exchange rates. We find strong empirical support for long-horizon predictability, and we explain why it is difficult to exploit this predictability in real-time forecasts. Our results not only lend support to economists' beliefs that the exchange rate is inherently predictable, but they also help us to understand the reluctance of applied forecasters to abandon chartist methods in favor of models based on economic fundamentals.

On the purchasing power parity puzzle

A puzzle concerning purchasing power parity is examined: Although the immense exchange rate volatility suggests a likely major role of nominal shocks under sticky prices, the observed half-life persistence of the real exchange rate seems excessively high to be rationalized by price stickiness. This study analyzes carefully the adjustment dynamics of real exchange rates through impulse response analysis. Half-life estimates are found to have substantial imprecision. Moreover, the dynamic response pattern suggests that the shock response is initially amplified before dissipating and that such non-monotonic dynamics can contribute to more than one-third of the observed persistence of real exchange rates.