Working Paper: NBER ID: w4952
Authors: Kenneth A. Froot; Kenneth Rogoff
Abstract: This paper reviews the large and growing literature which tests PPP and other models of the long-run real exchange rate. We distinguish three different stages of PPP testing and focus on what has been learned from each. The most important overall lesson has been that the real exchange rate appears stationary over sufficiently long horizons. Simple, univariate random walk specifications can be rejected in favor of stationary alternatives. However, we argue that multivariate tests, which ask whether any linear combination of prices and exchange rates are stationary, have not necessarily provided meaningful rejections of nonstationarity. We also review a number of other theories of the long run real exchange rate -- including the Balassa-Samuelson hypothesis -- as well as the evidence supporting them. We argue that the persistence of real exchange rate movements can be generated by a number of sensible models and that Balassa- Samuelson effects seem important, but mainly for countries with widely disparate levels of income of growth. Finally, this paper presents new evidence testing the law of one price on 200 years of historical commodity price data for England and France, and uses a century of data from Argentina to test the possibility of sample-selection bias in tests of long-run PPP.
Keywords: Purchasing Power Parity; Real Exchange Rates; Balassa-Samuelson Hypothesis
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| real exchange rate is not a random walk (F31) | shocks to the real exchange rate damp out over time (F31) |
| rich countries (O57) | higher real exchange rates (F31) |
| fast-growing countries (O57) | appreciations in their real exchange rates (F31) |
| persistence of real exchange rate movements (F31) | explained by various theoretical models (C20) |
| historical commodity price data from England and France and a century of data from Argentina (N53) | evidence regarding the law of one price (D41) |
| sample-selection bias in tests of long-run PPP (F31) | potential issues (P27) |