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VECM estimations of the PPP reversion rate revisited: the conventional role of relative price adjustment restored

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  • Kim, Hyeongwoo

Abstract

Cheung et al. (2004) use a vector error correction model (VECM) for the current float nominal exchange rate and the relative price data and claim that the sluggish Purchasing Power Parity (PPP) reversion is primarily driven by the nominal exchange rate, not by relative price adjustment, which is at odds with the conventional sticky-price models. Our major findings are as follows. First, we suggest cases where VECMs are of limited usefulness even when all the variables in the system are not weakly exogenous. Second, using century-long exchange rates, we find that the relative price plays an important role for PPP reversion when real shocks occur. Third, protracted hump-shaped responses of real exchange rates are frequently observed when there is a relative price shock, leading to sluggish adjustments toward PPP. Nominal exchange rate shocks generate humped dynamics much less frequently.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 33005.

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Date of creation: Aug 2011
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Handle: RePEc:pra:mprapa:33005

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Keywords: Purchasing Power Parity; Convergence Rate; Half-Life; Up-Life; Quarter-Life; Hump-Shaped Response; Variance Decomposition;

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  1. Kenneth A. Froot & Kenneth Rogoff, 1994. "Perspectives on PPP and Long-Run Real Exchange Rates," NBER Working Papers 4952, National Bureau of Economic Research, Inc.
  2. Maurice Obstfeld and Kenneth Rogoff., 2000. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," Center for International and Development Economics Research (CIDER) Working Papers, University of California at Berkeley C00-112, University of California at Berkeley.
  3. Pesaran, M. Hashem & Shin, Yongcheol, 1996. "Cointegration and speed of convergence to equilibrium," Journal of Econometrics, Elsevier, vol. 71(1-2), pages 117-143.
  4. Charles Engel & James Morley, 2000. "The Adjustment of Prices and the Adjustment of the Exchange Rate," Discussion Papers in Economics at the University of Washington, Department of Economics at the University of Washington 0009, Department of Economics at the University of Washington.
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  7. Chari, V V & Kehoe, Patrick J & McGrattan, Ellen R, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 69(3), pages 533-63, July.
  8. Yin-wong Cheung & Kon S. Lai & Michael Bergman, 2003. "Dissecting the PPP Puzzle: The Unconventional Roles of Nominal Exchange Rate and Price Adjustments," Working Papers 102003, Hong Kong Institute for Monetary Research.
  9. Serena Ng & Pierre Perron, 1997. "Lag Length Selection and the Construction of Unit Root Tests with Good Size and Power," Boston College Working Papers in Economics 369, Boston College Department of Economics, revised 01 Sep 2000.
  10. Hyeongwoo Kim, 2012. "Generalized Impulse Response Analysis: General or Extreme?," Auburn Economics Working Paper Series auwp2012-04, Department of Economics, Auburn University.
  11. Alan M. Taylor, 2000. "Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling and Specification Biases in Mean-Reversion Tests of the Law of One Price," NBER Working Papers 7577, National Bureau of Economic Research, Inc.
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  16. Claude Lopez & Christian J. Murray & David H. Papell, 2004. "State of the Art Unit Root Tests and Purchasing Power Parity," University of Cincinnati, Economics Working Papers Series, University of Cincinnati, Department of Economics 2004-04, University of Cincinnati, Department of Economics.
  17. Alan M. Taylor, 2000. "A Century of Purchasing-Power Parity," NBER Working Papers 8012, National Bureau of Economic Research, Inc.
  18. J�n Steinsson, 2008. "The Dynamic Behavior of the Real Exchange Rate in Sticky Price Models," American Economic Review, American Economic Association, vol. 98(1), pages 519-33, March.
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  20. Eichenbaum, Martin & Evans, Charles L, 1995. "Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 110(4), pages 975-1009, November.
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Cited by:
  1. Woo, Kai-Yin & Lee, Shu-Kam & Chan, Alan, 2014. "Non-linear adjustments to intranational PPP," Journal of Macroeconomics, Elsevier, vol. 40(C), pages 360-371.

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