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Further Evidence on PPP Adjustment Speeds: the Case of Effective Real Exchange Rates and the EMS

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  • Ivan Paya
  • Ioannis A. Venetis
  • David A. Peel

Abstract

Two different approaches intend to resolve the 'puzzling' slow convergence to purchasing power parity (PPP) reported in the literature [see Rogoff (1996), "Journal of Economic Literature", Vol. 34.] On the one hand, there are models that consider a non-linear adjustment of real exchange rate to PPP induced by transaction costs. Such costs imply the presence of a certain transaction band where adjustment is too costly to be undertaken. On the other hand, there are models that relax the 'classical' PPP assumption of constant equilibrium real exchange rates. A prominent theory put together by Balassa (1964, "Journal of Political Economy", Vol. 72) and Samuelson (1964 "Review of Economics and Statistics", Vol. 46), the BS effect, suggests that a non-constant real exchange rate equilibrium is induced by different productivity growth rates between countries. This paper reconciles those two approaches by considering an exponential smooth transition-in-deviation non-linear adjustment mechanism towards non-constant equilibrium real exchange rates within the EMS (European Monetary System) and effective rates. The equilibrium is proxied, in a theoretically appealing manner, using deterministic trends and the relative price of non-tradables to proxy for BS effects. The empirical results provide further support for the hypothesis that real exchange rates are well described by symmetric, nonlinear processes. Furthermore, the half-life of shocks in such models is found to be dramatically shorter than that obtained in linear models. Copyright 2003 Blackwell Publishing Ltd.

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Bibliographic Info

Article provided by Department of Economics, University of Oxford in its journal Oxford Bulletin of Economics and Statistics.

Volume (Year): 65 (2003)
Issue (Month): 4 (09)
Pages: 421-437

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Handle: RePEc:bla:obuest:v:65:y:2003:i:4:p:421-437

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