Purchasing Power Parity and New Trade Theory
35 Pages Posted: 29 Jan 2006
Date Written: February 2002
This paper theoretically derives and empirically tests the implications of a new trade theory framework for the systematic movements in the real exchange rate. It focuses on the effect of imperfect substitutability of tradables and on the importance of competitiveness, for which we construct an original proxy. Using a panel dynamic OLS estimation of nine bilateral US dollar real exchange rates, we derive long-run coefficients for relative productivity and competitiveness in the tradable and non-tradable sectors, controlling for standard macroeconomic variables. The implications of imperfect substitutability of tradables fit the data better than the standard neoclassical assumption of price equalization. Our new measure of competitiveness is statistically significant in explaining deviations from PPP.
Keywords: New trade theory, real exchange rates, purchasing power parity, productivity differentials, the PPP puzzle
JEL Classification: F31
Suggested Citation: Suggested Citation