Working Paper: CEPR ID: DP3715
Authors: Jean Imbs; Haroon Mumtaz; Morten Ravn; Hélène Rey
Abstract: We show the importance of a dynamic aggregation bias in accounting for the PPP puzzle. We prove that established time-series and panel methods substantially exaggerate the persistence of real exchange rates because of heterogeneity in the dynamics of disaggregated relative prices. When heterogeneity is properly taken into account, estimates of the real exchange rate half-life fall dramatically - to little more than one year - or significantly below Rogoff?s ?consensus view? of three to five years. We show that corrected estimates are consistent with plausible nominal rigidities, thus, arguably, solving the PPP puzzle.
Keywords: aggregation; parameter heterogeneity; purchasing power parity; real exchange rate persistence
JEL Codes: C43; F36; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| cross-sectoral heterogeneity (C21) | overestimation of the persistence of real exchange rates (F31) |
| failure to account for cross-sectoral heterogeneity (C21) | inflated estimates of persistence (C41) |
| properly accounting for heterogeneity (C21) | drop in estimates of real exchange rate halflife (F31) |
| aggregation bias (C43) | positive bias in halflife estimates (C41) |
| failure to account for heterogeneity (C21) | correlation between regressors and residuals (C29) |
| corrected estimates (C51) | resolution of the PPP puzzle (D74) |
| corrected estimates (C51) | consistency with economic theory regarding nominal rigidities (D10) |