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The micro-macro disconnect of purchasing power parity

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  • Paul R. Bergin
  • Reuven Glick
  • Jyh-Lin Wu

Abstract

The persistence of aggregate real exchange rates is a prominent puzzle, particularly since adjustment of international relative prices in microeconomic data is much faster. This paper finds that adjustment to the law of one price in disaggregated data is not just a faster version of the adjustment to purchasing power parity in the aggregate data; while aggregate real exchange rate adjustment works primarily through the foreign exchange market, adjustment in disaggregated data is a qualitatively distinct process, working through adjustment in local-currency goods prices. These distinct adjustment dynamics appear to arise from distinct classes of shocks generating macro and micro price deviations. A vector error correction model nesting aggregate and disaggregated relative prices permits identification of distinct macroeconomic and good-specific shocks. When half-lives are estimated conditional on shocks, the macro-micro disconnect puzzle disappears: microeconomic relative prices adjust to macro shocks just as slowly as do aggregate real exchange rates. These results provide evidence against theories of real exchange rate behavior based on sticky prices and on heterogeneity across goods.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2010-14.

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Date of creation: 2010
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Handle: RePEc:fip:fedfwp:2010-14

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Keywords: Foreign exchange rates ; Purchasing power parity ; Prices;

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References

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  1. Bartosz Mackowiak & Mirko Wiederholt, 2004. "Optimal Sticky Prices under Rational Inattention," SFB 649 Discussion Papers SFB649DP2005-040, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany, revised Jul 2005.
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  5. Mario J. Crucini & Mototsugu Shintani, 2002. "Persistence in Law-Of-One-Price Deviations: Evidence from Micro-Data," Vanderbilt University Department of Economics Working Papers 0222, Vanderbilt University Department of Economics, revised Jul 2004.
  6. Jean Imbs & Haroon Mumtaz & Morton O. Ravn & Helene Rey, 2002. "PPP Strikes Back: Aggregation and the Real Exchange Rate," NBER Working Papers 9372, National Bureau of Economic Research, Inc.
  7. Jon Steinsson, 2005. "The Dynamic Behavior of the Real Exchange Rate in Sticky Price Models," Economics wp28_jonst, Department of Economics, Central bank of Iceland.
  8. Fisher, Eric O'N & Park, Joon Y, 1991. "Testing Purchasing Power Parity under the Null Hypothesis of Co-integration," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 101(409), pages 1476-84, November.
  9. Charles Engel & James C. Morley, 2001. "The Adjustment of Prices and the Adjustment of the Exchange Rate," NBER Working Papers 8550, National Bureau of Economic Research, Inc.
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  11. Shiu-Sheng Chen & Charles Engel, 2004. "Does "Aggregation Bias" Explain the PPP Puzzle?," NBER Working Papers 10304, National Bureau of Economic Research, Inc.
  12. Haroon Mumtaz & Jean Imbs & Morten O. Ravn & Helene Rey, 2003. "PPP Strikes Back," IMF Working Papers 03/68, International Monetary Fund.
  13. Jyh-Lin Wu & Pei-Fen Chen & Ching-Nun Lee, 2009. "Purchasing Power Parity, Productivity Differentials And Non-Linearity," Manchester School, University of Manchester, vol. 77(3), pages 271-287, 06.
  14. David Parsley Shang-Jin Wei, 2002. "Currency Arrangements And Goods Market Integration: A Price Based Approach," International Finance, EconWPA 0211004, EconWPA.
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  16. Yin-Wong Cheung & Kon S. Lai & Michael Bergman, 2003. "Dissecting the PPP Puzzle: The Unconventional Roles of Nominal Exchange Rate and Price Adjustment," CESifo Working Paper Series 924, CESifo Group Munich.
  17. Parsley, David C & Wei, Shang-Jin, 1996. "Convergence to the Law of One Price without Trade Barriers or Currency Fluctuations," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 111(4), pages 1211-36, November.
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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Deviations from PPP: a micro-macro disconnect?
    by Economic Logician in Economic Logic on 2010-07-21 14:22:00
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Cited by:
  1. Takayuki Tsuruga & Mototsugu Shintani & Mario J. Crucini, 2011. "Do Sticky Prices Increase Real Exchange Rate Volatility at the Sector Level?," 2011 Meeting Papers 784, Society for Economic Dynamics.
  2. Georg H. Strasser, 2011. "Exchange Rate Pass-Through and Credit Constraints: Firms Price to Market as Long as They Can," Boston College Working Papers in Economics 788, Boston College Department of Economics, revised 13 Feb 2012.

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