DP3715 PPP Strikes Back: Aggregation and the Real Exchange Rate

Author(s): Jean Imbs, Haroon Mumtaz, Morten O Ravn, Hélène Rey
Publication Date: January 2003
Keyword(s): aggregation, parameter heterogeneity, purchasing power parity, real exchange rate persistence
JEL(s): C43, F36, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3715

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 that corrected estimates are consistent with plausible nominal rigidities, thus, arguably, solving the PPP puzzle.