Sticky Prices and the Purchasing Power Parity Puzzle
35 Pages Posted: 2 Feb 2004
Date Written: January 14, 2004
This paper investigates the Purchasing Power Parity Puzzle in the context of a Vector Autoregressive(VAR) model, where the real exchange rate is Granger caused by macroeconomic variables, suggested by 'sticky-price' theories of exchange rate determination. By doing this, we are able to discern the relative effect of nominal price rigidities on the speed of adjustment of the real exchange rate towards long-run PPP. We first show that the impulse response function of a variable participating in the VAR is not, in general, the same with the impulse response function obtained from the equivalent ARMA representation of this variable, if the latter is Granger caused by other variables in the system. The difference between the two functions captures the effects of the Granger-causing variables on the dynamic adjustment process of the variable of interest. Our empirical results for a set of four currencies suggest that price stickiness accounts for 22% to 50% of the half-life of innovations in the real exchange rate.
Keywords: Real exchange rate, persistence measures, nominal rigidities, VAR, impulse response
JEL Classification: F31, C32
Suggested Citation: Suggested Citation