A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings

TY - UNPB

T1 - A Resolution of the Purchasing Power Parity Puzzle

T2 - Imperfect Knowledge and Long Swings

AU - Frydman, Roman

AU - Goldberg, Michael D.

AU - Johansen, Søren

AU - Juselius, Katarina

N1 - JEL classification: F31, F41, G15, G17

PY - 2008

Y1 - 2008

N2 - Asset prices undergo long swings that revolve around benchmark levels. In currency markets, fluctuations involve real exchange rates that are highly persistent and that move in near-parallel fashion with nominal rates. The inability to explain these two regularities with one model has been called the "Purchasing Power Parity puzzle". In this paper, we trace the puzzle to exchange rate modelers' use of the "Rational Expectations Hypothesis". We show that once imperfect knowledge is recognized, a monetary model is able to account for the puzzle, as well as other salient features of the data, including the long-swings behavior of exchange rates.

AB - Asset prices undergo long swings that revolve around benchmark levels. In currency markets, fluctuations involve real exchange rates that are highly persistent and that move in near-parallel fashion with nominal rates. The inability to explain these two regularities with one model has been called the "Purchasing Power Parity puzzle". In this paper, we trace the puzzle to exchange rate modelers' use of the "Rational Expectations Hypothesis". We show that once imperfect knowledge is recognized, a monetary model is able to account for the puzzle, as well as other salient features of the data, including the long-swings behavior of exchange rates.

KW - Faculty of Social Sciences

KW - PPP puzzle

KW - rational expectations hypothesis

M3 - Working paper

BT - A Resolution of the Purchasing Power Parity Puzzle

PB - Department of Economics, University of Copenhagen

ER -