Topic 3: Exchange RatesTopic 3: Exchange Rates

Rogoff, K. (1996) “The Purchasing Rogoff, K. (1996) “The Purchasing Power Parity Puzzle” Journal of Power Parity Puzzle” Journal of Economic Literature, Vol. 34, No.2Economic Literature, Vol. 34, No.2

Taylor and Taylor (2004) “The Taylor and Taylor (2004) “The Purchasing Power Parity Debate” Purchasing Power Parity Debate” Journal of Economic Perspectives, Journal of Economic Perspectives, Fall.Fall.

Purchasing Power ParityPurchasing Power Parity

Some evidence that real exchange rates Some evidence that real exchange rates move toward PPP over the long runmove toward PPP over the long run

Speed of convergence to PPP very slowSpeed of convergence to PPP very slow Half life of 3-5 yearsHalf life of 3-5 years

Short-run deviations from PPP are large Short-run deviations from PPP are large and volatileand volatile

PPP works better for producer prices PPP works better for producer prices than consumer pricesthan consumer prices

How do we reconcile slow How do we reconcile slow convergence with large convergence with large

volatility?volatility?

Monetary and financial shocksMonetary and financial shocks Large volatility but not slow Large volatility but not slow

convergenceconvergence

Real shocksReal shocks Slow convergence but not large volatilitySlow convergence but not large volatility

Law of one priceLaw of one price

Large and volatile deviations from Large and volatile deviations from LOOP for many goodsLOOP for many goods

Deviations often reflect nominal Deviations often reflect nominal exchange rate movementsexchange rate movements

Boarder effects are large (Engle and Boarder effects are large (Engle and Rogers, AER, 1996)Rogers, AER, 1996)

Long-run convergence to Long-run convergence to PPPPPP

PPP fails spectacularly in the short PPP fails spectacularly in the short runrun

Failure in part reflects stickiness in Failure in part reflects stickiness in nominal price nominal price Not the only story; otherwise relatively Not the only story; otherwise relatively

quick convergence to PPPquick convergence to PPP No evidence of quick convergence to No evidence of quick convergence to

PPPPPP

Speed of convergenceSpeed of convergence

Many studies cannot reject hypothesis that Many studies cannot reject hypothesis that real exchange rates follow random walksreal exchange rates follow random walks Meese and Rogoff (1983)Meese and Rogoff (1983) May reflect lack of powerMay reflect lack of power

Studies using longer data sets and more Studies using longer data sets and more modern techniques generally find half-life modern techniques generally find half-life for PPP deviations of 3-5 yearsfor PPP deviations of 3-5 years But these studies mix data for fixed and But these studies mix data for fixed and

floating rate eras.floating rate eras.