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Quantifying the Half-Life of Deviations from PPP: The Role of Economic Priors

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Listed author(s):
  • Kilian, L.
  • Zha, T.

Abstract

The half-life of deviations from purchasing power parity (PPP) plays a central role in the ongoing debate about the ability of macroeconomic models to account for the time series behavior of the real exchange rate. The main contribution of this paper is a general framework in which alternative priors for the half-life of deviations from PPP can be examined. We show how to incorporate formally the prior views of economists about the half-life. In our empirical analysis we provide two examples of such priors. One example is a consensus prior consistent with widely held views among economists with a professional interest in the PPP debate. The other example is a relatively diffuse prior designed to capture a large degree of uncertainty about the half-life. Our methodology allows us to make explicit probability statements about the half-life and to assess the likelihood that the half-life exceeds a given number of years, without taking a stand on whether the data have a unit root or not. We find only very limited support for the common view in the PPP literature that the half-life is between three and five years.

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Paper provided by Research Seminar in International Economics, University of Michigan in its series Working Papers with number 450.

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Length: 33 pages
Date of creation: 1999
Handle: RePEc:mie:wpaper:450
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ANN ARBOR MICHIGAN 48109

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Web page: http://fordschool.umich.edu/rsie/
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Keywords: TIME SERIES ; ECONOMIC MODELS ; EXCHANGE RATE;

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Find related papers by JEL classification:
  • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
  • F30 - International Economics - - International Finance - - - General
  • F31 - International Economics - - International Finance - - - Foreign Exchange
  • B23 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Econometrics; Quantitative and Mathematical Studies

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Cited by:

  1. Chan, Tze-Haw, 2002. "Dynamic financial linkages among the Asia Pacific economies: an empirical assessment of real interest parity condition," MPRA Paper 34642, University Library of Munich, Germany.
  2. Chan, Tze-Haw & Khong, Wye Leong Roy & Baharumshah, Ahmad Zubaidi, 2003. "Dynamic Financial Linkages of Japan and ASEAN Economies: An Application of Real Interest Parity," MPRA Paper 2209, University Library of Munich, Germany, revised 2003.

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