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A Behavioral Explanation for the Puzzling Persistence of the Aggregate Real Exchange Rate

Author

Listed:
  • Mario J. Crucini
  • Mototsugu Shintani
  • Takayuki Tsuruga

Abstract

At the aggregate level, the observation that deviations from purchasing power parity (PPP) are too persistent to be accounted for solely by nominal rigidities has long been a puzzle (Rogoff, 1996). In addition, microeconomic evidence suggests that deviations from the law of one price (LOP) are less persistent than PPP deviations. To reconcile these two empirical anomalies, we incorporate the behavioral inattention approach of Gabaix (2014) into a two-country sticky-price model. Our model shows that firms’ behavioral inattention to the aggregate component of real marginal costs generates an endogenous dependence of LOP deviations on PPP deviations. We find strong supporting evidence for this particular formulation of behavioral inattention. Calibrating our model with the estimated degree of attention, we show that our model can fully account for the two empirical anomalies. PPP deviations are more than twice as persistent as those implied by nominal rigidities alone, while the persistence of LOP deviations is about two-thirds that of PPP deviations.

Suggested Citation

  • Mario J. Crucini & Mototsugu Shintani & Takayuki Tsuruga, 2021. "A Behavioral Explanation for the Puzzling Persistence of the Aggregate Real Exchange Rate," ISER Discussion Paper 1121r, Institute of Social and Economic Research, The University of Osaka, revised May 2025.
    • Handle: RePEc:dpr:wpaper:1121r
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    Cited by:

    1. Seunghoon Na & Yinxi Xie, 2023. "A Behavioral New Keynesian Model of a Small Open Economy Under Limited Foresight," Staff Working Papers 23-44, Bank of Canada.
    2. Marco Airaudo & Ina Hajdini, 2021. "Consistent Expectations Equilibria In Markov Regime Switching Models And Inflation Dynamics," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 62(4), pages 1401-1430, November.

    More about this item

    JEL classification:

    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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