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Quantifying the Half-Life of Deviations from PPP: The Role of Economic Priors

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  • Kilian, Lutz
  • Zha, Tao

Abstract

The half-life of deviations from purchasing power parity (PPP) plays a central role in the ongoing debate about the ability of macroeconomic models to account for the time series behaviour of the real exchange rate. The main contribution of this paper is a general framework in which alternative priors for the half-life of deviations from PPP can be examined. We show how to incorporate formally the prior views of economists about the half-life. In our empirical analysis we provide two examples of such priors. One example is a consensus prior consistent with widely held views among economists with a professional interest in the PPP debate. The other example is a relatively diffuse prior designed to capture a large degree of uncertainty about the half-life. Our methodology allows us to make explicit probability statements about the half-life and to assess the likelihood that the half-life exceeds a given number of years, without taking a stand on whether the data have a unit root or not. We find only very limited support for the common view in the PPP literature that the half-life is between three and five years.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2334.

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Date of creation: Dec 1999
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Handle: RePEc:cpr:ceprdp:2334

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Keywords: Half-Life; Likelihood; Mean Reversion; Persistence; Purchasing Power Parity;

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References

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Cited by:
  1. Chan, Tze-Haw & Khong, Wye Leong Roy & Baharumshah, Ahmad Zubaidi, 2003. "Dynamic Financial Linkages of Japan and ASEAN Economies: An Application of Real Interest Parity," MPRA Paper 2209, University Library of Munich, Germany, revised 2003.
  2. Chan, Tze-Haw, 2002. "Dynamic financial linkages among the Asia Pacific economies: an empirical assessment of real interest parity condition," MPRA Paper 34642, University Library of Munich, Germany.

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