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A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings

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Author Info
Roman Frydman (New York University)
Michael D. Goldberg (University of New Hampshire)
Søren Johansen (Department of Economics, University of Copenhagen)
Katarina Juselius (Department of Economics, University of Copenhagen)

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Abstract

Asset prices undergo long swings that revolve around benchmark levels. In currency markets, fluctuations involve real exchange rates that are highly persistent and that move in near-parallel fashion with nominal rates. The inability to explain these two regularities with one model has been called the "Purchasing Power Parity puzzle". In this paper, we trace the puzzle to exchange rate modelers' use of the "Rational Expectations Hypothesis". We show that once imperfect knowledge is recognized, a monetary model is able to account for the puzzle, as well as other salient features of the data, including the long-swings behavior of exchange rates.

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Paper provided by University of Copenhagen. Department of Economics in its series Discussion Papers with number 08-31.

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Length: 32 pages
Date of creation: Dec 2008
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Handle: RePEc:kud:kuiedp:0831

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Related research
Keywords: PPP puzzle; long swings; imperfect knowledge; rational expectations hypothesis;

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting

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