DP7902 The Harrod-Balassa-Samuelson Hypothesis: Real Exchange Rates and their Long-Run Equilibrium

Author(s): Yanping Chong, Ņscar Jordą, Alan M. Taylor
Publication Date: June 2010
Keyword(s): cointegration, Harrod-Balassa-Samuelson hypothesis, local projections, panel data
JEL(s): C32, F31, F41, F47
Programme Areas: International Macroeconomics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=7902

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