Working Paper: CEPR ID: DP4495
Authors: Alan M. Taylor; Mark P. Taylor
Abstract: Originally propounded by the 16th-century scholars of the University of Salamanca, the concept of purchasing power parity (PPP) was revived in the interwar period in the context of the debate concerning the appropriate level at which to re-establish international exchange rate parities. Broadly accepted as a long-run equilibrium condition in the post-war period, it first was advocated as a short-run equilibrium by many international economists in the first few years following the breakdown of the Bretton Woods system in the early 1970s and then increasingly came under attack on both theoretical and empirical grounds from the late 1970s to the mid 1990s. Accordingly, over the last three decades, a large literature has built up that examines how much the data deviated from theory, and the fruits of this research have provided a deeper understanding of how well PPP applies in both the short run and the long run. Since the mid 1990s, larger datasets and nonlinear econometric methods, in particular, have improved estimation. As deviations narrowed between real exchange rates and PPP, so did the gap narrow between theory and data, and some degree of confidence in long-run PPP began to emerge again. In this respect, the idea of long-run PPP now enjoys perhaps its strongest support in more than 30 years, a distinct reversion in economic thought.
Keywords: exchange rates; long-run equilibrium; nonlinearity; purchasing power parity; real exchange rates
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Inflation rates (E31) | Exchange rate changes (F31) |
| Real exchange rates (F31) | Mean reversion towards PPP (F31) |
| Deviations from PPP (F31) | Mean reversion of real exchange rates (F31) |
| Market frictions and transaction costs (G19) | Deviations from PPP (F31) |
| Shocks to real exchange rates (F31) | Speed of adjustment to PPP (F31) |
| Larger deviations from PPP (F31) | Faster convergence back to equilibrium (D50) |