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Adjustment Speeds of Nominal Exchange Rates and Prices toward Purchasing Power Parity

Listed author(s):
  • Iwatsubo, Kentaro

The conventional view, as expounded by sticky-price models, is that price adjustment determines the PPP reversion rate. Contrary to this, recent studies indicate that nominal exchange rates converge much more slowly to PPP than nominal prices. This paper investigates how adjustment speeds of nominal exchange rates and prices toward PPP are affected by exchange rate regimes by employing a vector error correction model (VECM). We find evidence from 22 OECD countries that the adjustment speed of nominal exchange rates toward PPP is faster than that of prices as nominal exchange rates are relatively stable. This suggests that nominal exchange rate volatility has significant bearings on the variables primarily driving adjustment toward the long-run equilibrium level defined by PPP. We also show that the real exchange rates converge faster to the long-run PPP level for the relatively stable exchange rates, consistent with the evidence to support the significant mean reversion of real exchange rates for the gold standard period.

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Paper provided by Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University in its series CEI Working Paper Series with number 2005-11.

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Length: 21 p.
Date of creation: Jan 2006
Handle: RePEc:hit:hitcei:2005-11
Note: First draft: September 28, 2005
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  1. Cheung, Yin-Wong & Lai, Kon S. & Bergman, Michael, 2004. "Dissecting the PPP puzzle: the unconventional roles of nominal exchange rate and price adjustments," Journal of International Economics, Elsevier, vol. 64(1), pages 135-150, October.
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