Working Paper: CEPR ID: DP7902
Authors: Yanping Chong; Scar Jord; Alan M. Taylor
Abstract: Frictionless, perfectly competitive traded-goods markets justify thinking of purchasing power parity (PPP) as the main driver of exchange rates in the long-run. But differences in the traded/non-traded sectors of economies tend to be persistent and affect movements in local price levels in ways that upset the PPP balance (the underpinning of the Harrod-Balassa-Samuelson hypothesis, HBS). This paper uses panel-data techniques on a broad collection of countries to investigate the long-run properties of the PPP/HBS equilibrium using novel local projection methods for cointegrated systems. These semi-parametric methods isolate the long-run behavior of the data from contaminating factors such as frictions not explicitly modelled and thought to have effects only in the short-run. Absent the short-run effects, we find that the estimated speed of reversion to long-run equilibrium is much higher. In addition, the HBS effects means that the real exchange rate is converging not to a steady mean, but to a slowly to a moving target. The common failure to properly model this effect also biases the estimated speed of reversion downwards. Thus, the so-called
Keywords: cointegration; Harrod-Balassa-Samuelson hypothesis; local projections; panel data
JEL Codes: C32; F31; F41; F47
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Differences in productivity across countries (O47) | persistent deviations from purchasing power parity (PPP) (F31) |
| Differences in productivity across countries (O47) | long-run real exchange rate equilibrium (F31) |
| HBS effects (I12) | speed of reversion to long-run equilibrium (D59) |
| HBS effects (I12) | estimated speed of reversion (C59) |
| Short-run frictions (J69) | understanding of long-run dynamics (E32) |
| Failing to incorporate HBS effect (D29) | upwardly biased estimates of halflives (C41) |