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A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings

  • Roman Frydman

    (New York University)

  • Michael D. Goldberg

    (University of New Hampshire)

  • Søren Johansen

    (Department of Economics, University of Copenhagen)

  • Katarina Juselius

    (Department of Economics, University of Copenhagen)

Asset prices undergo long swings that revolve around benchmark levels. In currency markets, fluctuations involve real exchange rates that are highly persistent and that move in near-parallel fashion with nominal rates. The inability to explain these two regularities with one model has been called the "Purchasing Power Parity puzzle". In this paper, we trace the puzzle to exchange rate modelers' use of the "Rational Expectations Hypothesis". We show that once imperfect knowledge is recognized, a monetary model is able to account for the puzzle, as well as other salient features of the data, including the long-swings behavior of exchange rates.

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Paper provided by University of Copenhagen. Department of Economics in its series Discussion Papers with number 08-31.

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Length: 32 pages
Date of creation: Dec 2008
Date of revision:
Handle: RePEc:kud:kuiedp:0831
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