Exchange Rate Economics: Theories and Evidence

Purchasing power parity and the PPP puzzle 45
However,and as we shall see in more detail later,estimated half-lives are much
higher than 1 year. For example,for the post-Bretton Woods period when
currencies are examined on an individual basis, ρ turns out to be statistically
indistinguishable from unity. However,when data from prior to the post-Bretton
Woods regime,or when panel data are used for the post-Bretton Woods,there is
clear evidence of statistically significant mean reversion and the half-life falls within
the range of 3 to 5 years (see MacDonald 1995a; Rogoff 1996). Rogoff (1996) has
labelled such mean reversion speeds,combined with the large volatility of real
exchange rates as the PPP puzzle:
How can one reconcile the enormous short-term volatility of real exchange
rates with the extremely slow rate at which shocks appear to damp out? Most
explanations of short-term exchange rate volatility point to financial factors
such as changes in portfolio preferences,short-term asset price bubbles and
monetary shocks. Such shocks can have substantial effects on the real economy
in the presence of sticky nominal prices. Consensus estimates for the rate at
which PPP deviations damp,however,suggest a half-life of three to five years,
seemingly far too long to be explained by nominal rigidities. It is not difficult
to rationalize slow adjustment of real shocks if real shocks – shocks to tastes
and technology – are predominant. But existing models based on real shocks
cannot account for short-terms exchange-rate volatility.
(Rogoff 1996: 647–8)
As we shall see,one useful way of trying to understand and explain the PPP
puzzle is to decompose the overall (CPI-based) real exchange rate into two relative
price components,an internal and external component. To do this,we introduce
non-traded prices into our previous set-up in the following way. Assume that the
overall price level, p,is made up of a price level for traded goods,which,in turn,
is the sum of the n traded goods produced in the home and foreign country,and
the price level for non-traded goods,which is the sum of the m non-traded goods
produced:
p t = β t p T t
+ (1 − β t )p NT
t , 0