The purchasing power parity puzzle is worse than you think

The ‘‘purchasing power parity puzzle’’ is the difficulty of reconciling very high short-term volatility of real exchange rates with very slow rates of mean reversion. The strongest evidence of slow mean reversion comes from least squares estimates of first-order autoregressive models of the long-horizon dollar-sterling real exchange rate. Using median-unbiased estimation methods, we show that these methods underestimate the half-lives of PPP deviations, and thus overestimate the speed of mean reversion. When the specification is amended to allow for serial correlation, the speed of mean reversion falls even further. This makes resolution of the purchasing power parity puzzle more problematic.First version received: May 2003/Final version received: July 2004We thank Lutz Kilian, James Lothian, Mark Taylor, and two anonymous referees for helpful comments and suggestions.     

Sources of exchange rate fluctuations with Taylor rule fundamentals

This paper investigates the sources of exchange rate fluctuations when monetary policy follows a Taylor rule interest rate reaction function. We first present a simple dynamic exchange rate model with Taylor rule fundamentals which is triangular in the long-run impacts of shocks to the output market, the interest rate differential, and the Taylor rule. We then proceed to assess the relative importance of various shocks in exchange rate determination by estimating a structural VAR with long-run identification restrictions based on the triangular structure of the model. We find demand shocks to be less important than in earlier VAR studies, with both supply shocks and nominal shocks explaining a substantial part of real exchange rate fluctuations.     

Real exchange rate dynamics: Relative importance of Taylor‐rule fundamentals,monetary policy shocks,and risk‐premium shocks

We first show that the solution to the real exchange rate under the Taylor rule with interest rate smoothing can have two alternative representations—one based on a first‐order difference equation and the other based on a second‐order difference equation. Then, by comparing error terms from these two alternative representations and analyzing their second moments, we evaluate the relative importance of Taylor‐rule fundamentals, monetary policy shocks, and risk‐premium shocks in the dynamics of the real exchange rate. Empirical results suggest that the risk‐premium shock is the largest contributor to real exchange rate movements for all the countries examined, with the Taylor‐rule fundamentals and monetary policy shocks playing a limited role. These results are robust to various alternative sets of parameter values considered for the Taylor rule with interest rate smoothing.     

TAYLOR RULE REACTION COEFFICIENTS AND REAL EXCHANGE RATE PERSISTENCE

Recent literature has established a link between the persistence of real exchange rates and the degree of inertia in Taylor rule monetary policy reactions functions. This paper provides a different view on this link by investigating how the size of Taylor rule reaction coefficients impacts the adjustment dynamics of the real exchange rate. Within a stylized sticky‐price open‐economy macro model, it is demonstrated that a stronger interest rate reaction to inflation in the Taylor rule raises the convergence speed of the real exchange rate. Conversely, raising the coefficient on the output gap or attending to the exchange rate in an open‐economy version of the Taylor rule slows down real exchange rate adjustment. In all cases, more rapid convergence comes at the cost of stronger initial real exchange rate misalignments in the wake of monetary policy shocks.     

Median-unbiased estimation of structural change models: an application to real exchange rate persistence

Measuring deviations from purchasing power parity has been the subject of extensive investigation. The most common practice in empirical research for measuring real exchange rate persistence is to estimate univariate autoregressive (AR) time series models and calculate the half-life, defined as the number of periods for a unit shock to a time series to decay by 50%. In the presence of structural change, there are two potential biases in the parameter estimates of AR models: (1) a downward small sample median-bias and (2) an upward bias, which occurs when structural change is present and ignored. We conduct a variety of Monte Carlo simulations and demonstrate that the existence of structural change causes a substantial increase in the small sample bias documented in Andrews (1993). We then propose an extension of median-unbiased estimation, which explicitly accounts for structural change, and apply these methods to estimate half-lives of several long-horizon real exchange rates analysed by Lothian and Taylor (1996) and Taylor (2002). The upward bias from neglecting structural change dominates the downward median-bias for these real exchange rates. When structural change is present and accounted for, the median-unbiased half-lives towards a changing mean decrease and the confidence intervals tighten.     

Exchange rates of oil exporting countries and global oil price shocks: a nonlinear smooth-transition approach

This paper models logistic and exponential smooth transition adjustments of real exchange rates for six major oil-exporting countries in response to different shocks affecting oil prices. The logistic form captures asymmetric and the exponential form symmetric adjustments in regards to positive and negative oil price shocks. We chose oil-exporting countries that do not peg their exchange rates. For most countries, we detect no statistically significant non-linearities for the adjustment process of real exchange rate returns, be they asymmetric or symmetric, in response to oil supply shocks, idiosyncratic oil-market-specific shocks, and speculative oil-market shocks. Exceptions are oil supply shocks in the UK and possibly Brazil, where exchange rates respond nonlinearly, though the effects are symmetric for both countries. On the other hand, global aggregate demand shocks, which are shocks not originating directly in the oil market, have nonlinear asymmetric effects on real exchange rate returns for Canada, Mexico, Norway and Russia, and nonlinear symmetric effects for Brazil and the UK.     

Has Australia's floating exchange rate regime been optimal?

This paper develops a straightforward theoretical framework for evaluating exchange rate regime choice for small economies. It proposes that a floating exchange rate minimises national income and employment variation when real macroeconomic shocks predominate, whereas a pegged exchange rate achieves this goal should monetary shocks predominate. It then shows econometrically that, in the case of Australia, a floating exchange rate best suited the economy for the period 1985 to 2010, because real shocks were more significant than monetary shocks. Moreover, consistent with the theory, further results showing that a stronger (weaker) exchange rate correlated with positive (negative) deviations from trend GDP affirm that a floating exchange rate regime was optimal for Australia over this time.     

Nonlinear Mean-Reversion in Real Exchange Rates: Toward a Solution To the Purchasing Power Parity Puzzles

We fit nonlinearly mean-reverting models to real dollar exchange rates over the post-Bretton Woods period, consistent with a theoretical literature on transactions costs in international arbitrage. The half lives of real exchange rate shocks, calculated through Monte Carlo integration, imply faster adjustment speeds than hitherto recorded. Monte Carlo simulations reconcile our results with the large empirical literature on unit roots in real exchange rates by showing that when the real exchange rate is nonlinearly mean reverting, standard univariate unit root tests have low power, while multivariate tests have much higher power to reject a false null hypothesis.     

Non-Traded Goods and Real Exchange Rate Fluctuations: A Structural VAR Analysis

Real exchange rate variance decompositions indicate that only a small fraction of real exchange rate movements can be attributed to changes in the relative price between traded and non-traded goods. This paper argues that those exercises, by ignoring the nature of the shocks behind real exchange rate changes, may be inadequate to measure the relative importance of non-traded goods prices. Instead, it proposes using a structural vector autoregression (SVAR) model to study the effects of shocks to the relative supply and relative demand for non-traded goods on the real exchange rate. The SVAR model is identified via long-run restrictions and is estimated for a group of advanced economies. The results indicate that for some countries, relative supply shocks can be a significant source of real exchange rate fluctuations.     

Excess volatility of real exchange rates in the EMS: some evidence from structural VARs

This paper argues that the effectiveness of the exchange rate mechanism (ERM) of the European Monetary System (EMS) should be gauged by its impact on the monetary component of real exchange rate variability. Nominal and real shocks are separated using a bivariate structural VAR applied to real exchange rate data of the six original member countries participating in the ERM and a control group consisting of Britain and the United States. The findings suggest that monetary shocks have been an important source of real exchange rate variability and that the ERM has been successful in reducing the incidence of monetary shocks across its member countries prior to the EMS currency crises of 1992–93, while being less successful thereafter.     

The impact of output and exchange rate volatility on fixed private investment: evidence from selected G7 countries

This study examines the impact of shocks to exchange rate and output uncertainty (volatility) on real private fixed investment (FI) in Canada, Germany, the United Kingdom and the United States. The analysis is conducted using vector autoregressive models that contain the price level, real output, the volatility of real output, the real exchange rate, the volatility of the real exchange rate, an interest rate and FI. The results yield important public policy implications with regard to the impact of output volatility of FI. Our analysis indicates that volatility shocks, measured as output volatility or exchange rate volatility, do not have a significant impact on FI for any country in our study.     

DELAYED OVERSHOOTING AND REAL EXCHANGE RATE PERSISTENCE IN AN IMPERFECT INFORMATION MODEL

Recent studies have pointed out that monetary shocks in sticky price models cannot generate real exchange rates that exhibit delayed overshooting and are highly persistent. This paper demonstrates that such exchange rate dynamics can be generated by incorporating incomplete information about the true nature of the monetary shock into a standard New Keynesian model of a small open economy.     

The changing nature of the real exchange rate: The role of central bank preferences

We investigate the sources of real exchange rate fluctuations. We do so, first, in the context of a DSGE model that explicitly considers the central bank's preferences. Then we estimate SVAR models, where shocks are identified by sign restrictions derived from the DSGE model. We perform this exercise for twelve countries, nine of which have adopted inflation targeting during the period analyzed. In sharp contrast to the previous evidence in the literature, we find that exchange rate (country risk premium) shocks have become the main drivers of real exchange rate dynamics, while real shocks play a less important role. Evidence from the DSGE model reveals that, as the central bank becomes more averse to inflation movements, and cares less about nominal exchange rate fluctuations, the impact of nominal shocks on the real exchange rate tends to increase, while the impact of real shocks decreases. Our results suggest that the adoption of inflation targeting, along with a floating exchange rate, contributes to a shift in the relative importance of demand and country risk premium shocks in determining the RER.     

Dissecting Exchange Rates and Fundamentals in the Modern Floating Era: The Role of Permanent and Transitory Shocks

In this paper, we apply a permanent–transitory decomposition method to analyze the link between nominal exchange rates and fundamentals in the modern floating era. The results suggest that transitory shocks dominate nominal exchange rate fluctuations, while permanent shocks dominate the variations in fundamentals. Therefore, the findings suggest that the nominal exchange rate should not be approximated by a pure random walk. Moreover, we find that unobserved fundamentals in the Taylor rule model can explain the transitory components in exchange rates.     

Fractionalization and long-run economic growth: webs and direction of association between the economic and the social -- South Africa as a time series case study

In this paper it is considered that the relationship between nominal exchange rate and prices depends on the nature of the shocks impacting the economy. In order to identify the sources of nominal exchange rate and relative price fluctuations we impose long-run restrictions on the dynamics of these variables through a 2-variable and 3-variable SVAR, respectively. This methodology is applied to data on the Spanish economy and find that supply and real demand shocks move nominal exchange rates and relative prices in opposite directions. Nominal shocks, however, move both variables in the same direction. Thus, in this case, only under nominal shocks may exchange rate depreciations fuel inflation.     

Portfolio allocation and international risk sharing

Abstract We show that recent explanations of the consumption‐real exchange rate anomaly that rely on goods and financial market frictions are not robust to introducing just one additional international asset. When portfolios are selected optimally, international trade in two nominal bonds implies a consumption‐real exchange rate correlation that is too high compared with the data even when there are many shocks. Monetary policy specification plays a potentially important role for the degree of risk sharing provided by nominal bonds, both in the benchmark model with only tradable and non‐tradable sector supply shocks and also in the model that allows for news.     

Do sticky prices increase real exchange rate volatility at the sector level?

We introduce the real exchange rate volatility curve as a useful device to understand the relationship between price stickiness and the fluctuations in Law of One Price deviations. In the presence of both nominal and real shocks, the theory predicts that the real exchange rate volatility curve is a U-shaped function of the degree of price stickiness. Using sector-level US–European real exchange rate data and frequency of price changes, we estimate the volatility curve and find the predominance of real effects over nominal effects. Good-by-good variance decompositions show that the relative contribution of nominal shocks is smaller at the sector level than what previous studies have found at the aggregate level, consistent with significant averaging out of good-specific real microeconomic shocks.     

Rational expectations,market shocks,and the exchange rate

The world economy has been subjected to numerous real shocks in recent years. In addition, purchasing-power parity seems to have collapsed. Critics of the monetary approach to the exchange rate have been quick to draw attention to these facts. This paper extends the basic framework of the monetary approach so that it provides a useful tool for explaining the impact of real shocks on the exchange rate and so that it is compatible with the existence of significant deviations from purchasing-power parity. The real shocks that are discussed include changes in commercial policy, the terms of trade, and productivity. It is demonstrated that real shocks influence the exchange rate through two distinct channels—a real-income channel and a deviations from purchasing-power-parity channel.     

Sources of Fluctuations in the Real Exchange Rates and Trade Balances of the G‐7: A Sign Restriction VAR Approach

This paper estimates structural vector autoregression models of output, the real exchange rate and trade balance for the group of seven leading advanced economies (G‐7). Unlike previous studies, we do not impose long‐run purchasing power parity as an identifying assumption; instead, the shocks underlying the model are structurally identified using a set of theory‐consistent sign restrictions. Empirical results show that nominal shocks account for most of the long‐run variability in trade balances across the G‐7 countries. We are able to attribute this finding to long‐run movements in the real exchange rate, as the real exchange rate is significantly affected by nominal shocks in the long run.     

Shock Persistence and Stochastic Trends in Australian Aggregate Output and Consumption*

The distinction between transitory and permanent shocks is at the centre of the debate on which class of models is best suited to represent economic variables: stationary models around a deterministic trend, or stationary models around a stochastic trend The debate u here focused on the Australian case. It is found that both aggregate output and consumption are characterized by stochastic trends, but without a transitory component This corresponds to a measure of shock persistence equal to one for both variables. For the specific case of aggregate output, this result may be interpreted as indicating the absence of business cycles