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Exchange rates, prices and their speed of adjustment

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Author Info

  • Fanelli Luca

    ()
    (Department of Statistical Sciences, University of Bologna, Italy)

  • Paruolo Paolo

    ()
    (Department of Economics, University of Insubria, Italy)

Abstract

This paper addresses the problem of measuring the speed of adjustment of exchange rates and relative prices to purchasing power parity (PPP), in the multivariate context of Vector Autoregressive Processes (VAR). We consider the speed of adjustment of one variable y in response to another variable x, where x, y belong to the VAR. We propose a multivariate measure defined as the forecasting horizon for which the cumulated interim multiplier of x on y surpasses a given fraction p of the corresponding total multiplier. This measure of speed for p = 1/2 coincides with the usual concept of half-life when restricted to univariate processes. We emphasize the importance to separate the concepts of long run e¤ect size and its speed of adjustment, where the latter is unambiguosly defined only when the long run e¤ect is non-zero. We discuss likelihood-based point estimators and confidence sets for this notion of half-life, and reconsider evidence on adjustment to PPP in monthly post-Bretton Woods data for five major industrialized countries against the U.S. dollar. Results show that nominal exchange rates bu¤er the entire adjustment to PPP disequilibrium, wheras relative prices do not adjust either in the short or the long run to PPP deviations. Concluding in such a situation that prices adjust faster than exchange rates is a matter of how one interprets the absence of short run and long run effects.

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File URL: http://eco.uninsubria.it/dipeco/Quaderni/files/QF2006_7.pdf
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Bibliographic Info

Paper provided by Department of Economics, University of Insubria in its series Economics and Quantitative Methods with number qf0607.

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Length: 35 pages
Date of creation: Sep 2006
Date of revision:
Handle: RePEc:ins:quaeco:qf0607

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Related research

Keywords: Invariance; Half-life; purchasing power parity; impact factors; speed of adjustment; vector equilibrium correction; upcrossing and downcrossing.;

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References

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  1. Knudsen, Thorbjorn, 2003. "Simon's selection theory: Why docility evolves to breed successful altruism," Journal of Economic Psychology, Elsevier, vol. 24(2), pages 229-244, April.
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  3. Secchi Davide & Bardone Emanuele, 2005. "Extending the Bounded Rationality Model: The Distributed Cognition Approach," Economics and Quantitative Methods qf0506, Department of Economics, University of Insubria.
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  5. Becker, Gary S, 1974. "A Theory of Social Interactions," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1063-93, Nov.-Dec..
  6. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279.
  7. Herbert Simon & Lindsay McSweeney, 2010. "A Behavioral Model of Rational Choice," CPI Journal, Competition Policy International, vol. 6.
  8. Secchi Davide, 2005. "Altruism and Selfish Behavior. The Docility Model Revisited," Economics and Quantitative Methods qf0505, Department of Economics, University of Insubria.
  9. Simon, Herbert A, 1979. "Rational Decision Making in Business Organizations," American Economic Review, American Economic Association, vol. 69(4), pages 493-513, September.
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