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The Adjustment of Prices and the Adjustment of the Exchange Rate

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  • Charles Engel
  • James Morley

Abstract

The purchasing power parity puzzle relates to the adjustment of real exchange rates. Real exchange rates are extremely volatile, suggesting that temporary shocks emanate from the monetary sector. But the half-life of real exchange rate deviations is extremely large -- 2.5 to 5 years. This half-life seems too large to be explained by the slow adjustment of nominal prices. We offer a different interpretation. We maintain that nominal exchange rates and prices need not converge at the same rate, as is implicit in rational-expectations sticky-price models of the exchange rate. Evidence from an unobserved components model for nominal prices and nominal exchange rates that imposes relative purchasing power parity in the long run indicates that nominal exchange rates converge much more slowly than nominal prices. The real puzzle is why nominal exchange rates converge so slowly.
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Suggested Citation

  • 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 0009, Department of Economics at the University of Washington.
  • Handle: RePEc:fth:washer:0009
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    as
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    JEL classification:

    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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