Working Paper: NBER ID: w9372
Authors: Jean Imbs; Haroon Mumtaz; Morten O. 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 corrected estimates are consistent with plausible nominal rigidities, thus, arguably, solving the puzzle. We also explain why traded goods prices account for the bulk of the persistence and volatility of the real exchange rate. The reason is that traded goods prices display dynamics that are more heterogeneous than non-traded ones.
Keywords: Real Exchange Rate; Purchasing Power Parity; Dynamic Aggregation Bias
JEL Codes: F36; F41; C43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Failure to account for sectoral heterogeneity in dynamics of relative prices (D59) | Positive bias in estimates of real exchange rate half-lives (F31) |
| Aggregation bias (C43) | Overestimation of persistence due to correlated regressors and residuals in pooled estimations (C51) |
| Corrected estimates (C51) | Align with plausible nominal rigidities (C54) |
| Degree of sectoral heterogeneity (F12) | Contributes to observed persistence in relative prices (F16) |
| Aggregation bias (C43) | Drives results rather than measurement error or sample length (C29) |