Working Paper: NBER ID: w15868
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 "PPP puzzle" is not as bad as we thought.
Keywords: Harrod-Balassa-Samuelson hypothesis; real exchange rates; long-run equilibrium; purchasing power parity
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| productivity differentials (O49) | real exchange rate (F31) |
| real exchange rate (F31) | long-run equilibrium (D59) |
| productivity differentials (O49) | long-run equilibrium (D59) |
| short-run frictions (J69) | adjustment dynamics (F32) |
| HBS effects (I12) | speed of reversion (C69) |