Topic 3: Exchange Rates Rogoff, K. (1996) “The Purchasing Power Parity Puzzle” Journal of Economic Literature, Vol. 34, No.2 Rogoff, K. (1996) “The Purchasing Power Parity Puzzle” Journal of Economic Literature, Vol. 34, No.2 Taylor and Taylor (2004) “The Purchasing Power Parity Debate” Journal of Economic Perspectives, Fall. Taylor and Taylor (2004) “The Purchasing Power Parity Debate” Journal of Economic Perspectives, Fall.

Purchasing Power Parity Some evidence that real exchange rates move toward PPP over the long run Some evidence that real exchange rates move toward PPP over the long run Speed of convergence to PPP very slow Speed of convergence to PPP very slow Half life of 3-5 years Half life of 3-5 years Short-run deviations from PPP are large and volatile Short-run deviations from PPP are large and volatile PPP works better for producer prices than consumer prices PPP works better for producer prices than consumer prices

How do we reconcile slow convergence with large volatility? Monetary and financial shocks Monetary and financial shocks Large volatility but not slow convergence Large volatility but not slow convergence Real shocks Real shocks Slow convergence but not large volatility Slow convergence but not large volatility

Law of one price Large and volatile deviations from LOOP for many goods Large and volatile deviations from LOOP for many goods Deviations often reflect nominal exchange rate movements Deviations often reflect nominal exchange rate movements Boarder effects are large (Engle and Rogers, AER, 1996) Boarder effects are large (Engle and Rogers, AER, 1996)

Long-run convergence to PPP PPP fails spectacularly in the short run PPP fails spectacularly in the short run Failure in part reflects stickiness in nominal price Failure in part reflects stickiness in nominal price Not the only story; otherwise relatively quick convergence to PPP Not the only story; otherwise relatively quick convergence to PPP No evidence of quick convergence to PPP No evidence of quick convergence to PPP

Speed of convergence Many studies cannot reject hypothesis that real exchange rates follow random walks Many studies cannot reject hypothesis that real exchange rates follow random walks Meese and Rogoff (1983) Meese and Rogoff (1983) May reflect lack of power May reflect lack of power Studies using longer data sets and more modern techniques generally find half-life for PPP deviations of 3-5 years Studies using longer data sets and more modern techniques generally find half-life for PPP deviations of 3-5 years But these studies mix data for fixed and floating rate eras. But these studies mix data for fixed and floating rate eras.