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Journal of Economic Literature Vol. XXXIV (June 1996), pp. 647-668
The Purchasing Power Parity Puzzle
I am grateful to Rudiger Dornbusch, Hali Edison, ]ohn Rogers, Susanne Trimbath, and to three anonymous referees for constructive suggestions on an earlier draft, and to Brian Doyle and Giovanni Olivei for excellent research assistance. The National Science Foundation and the Bradley Foundation provided research support.
Salamanca school in sixteenth century Spain,l purchasing power parity (PPP) is the disarmingly simple empirical proposition that, once converted to a common currency, national price levels should be equal. The basic idea is that if goods market arbitrage enforces broad parity in prices across a sufficient range of individual goods (the law of one price), then there should also be a high correlation in aggregate price levels. While few empirically literate economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates. Warm, fuzzy feelings about PPP are not, of course, a substitute for hard evidence. There is today an enormous and evergrowing empirical literature on PPP, one that has arrived at a surprising degree of consensus on a couple of basic facts. First, at long last, a number of recent studies have weighed in with fairly persuasive evidence that real exchange rates See Lawrence H. Officer (1982, ch. 3) for an extensive discussion of the origins of PPP theory; see also Dornbusch (1987).
IRST ARTICULATED by scholars of the
(nominal exchange rates adjusted for differences in national price levels) tend toward purchasing power parity in the very long run. Consensus estimates suggest, however, that the speed of convergence to PPP is extremely slow; deviations appear to damp out at a rate of roughly 15 percent per year. Second, short-run deviations from PPP are large and volatile. Indeed, the one-month conditional volatility of real exchange rates (the volatility of deviations from PPP) is of t h e same order of magnitude as the conditional volatility of nominal exchange rates. Price differential volatility is surprisingly large even when one confines attention to relatively homogenous classes of highly traded goods. The purchasing power parity puzzle then is this:...