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Aggregation and the PPP puzzle in a sticky-price model

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  • Carlos Carvalho
  • Fernanda Nechio

Abstract

We study the purchasing power parity (PPP) puzzle in a multi-sector, two-country, sticky- price model. Across sectors, firms differ in the extent of price stickiness, in accordance with recent microeconomic evidence on price setting in various countries. Combined with local currency pricing, this leads sectoral real exchange rates to have heterogeneous dynamics. We show analytically that in this economy, deviations of the real exchange rate from PPP are more volatile and persistent than in a counterfactual one-sector world economy that features the same average frequency of price changes, and is otherwise identical to the multi-sector world economy. When simulated with a sectoral distribution of price stickiness that matches the microeconomic evidence for the U.S. economy, the model produces a half-life of deviations from PPP of 39 months. In contrast, the half-life of such deviations in the counterfactual one-sector economy is only slightly above one year. As a by-product, our model provides a decomposition of this difference in persistence that allows a structural interpretation of the different approaches found in the empirical literature on aggregation and the real exchange rate. In particular, we reconcile the apparently conflicting findings that gave rise to the \"PPP Strikes Back debate\" (Imbs et al. 2005a,b and Chen and Engel 2005).

Suggested Citation

  • Carlos Carvalho & Fernanda Nechio, 2010. "Aggregation and the PPP puzzle in a sticky-price model," Working Paper Series 2010-06, Federal Reserve Bank of San Francisco.
  • Handle: RePEc:fip:fedfwp:2010-06
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    More about this item

    Keywords

    Purchasing power parity; Prices; Foreign exchange rates;
    All these keywords.

    JEL classification:

    • E00 - Macroeconomics and Monetary Economics - - General - - - General
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F30 - International Economics - - International Finance - - - General

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