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

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.