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PPP Strikes Back: Aggregation and the Real Exchange Rate

  • Jean Imbs
  • Haroon Mumtaz
  • Morton O. Ravn
  • Helene Rey

We show the importance of a dynamic aggregation bias in accounting for the PPP puzzle. We prove that established time series and panel methods substantially exaggerate the persistence of real exchange rates because of heterogeneity in the dynamics of disaggregated relative prices. When heterogeneity is properly taken into account, estimates of the real exchange rate half-life fall dramatically, to little more than one year, or significantly below Rogoff's consensus view' of three to five years. We show corrected estimates are consistent with plausible nominal rigidities, thus, arguably, solving the puzzle. We also explain why traded goods prices account for the bulk of the persistence and volatility of the real exchange rate. The reason is that traded goods prices display dynamics that are more heterogeneous than non-traded ones.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9372.

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Date of creation: Dec 2002
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Publication status: published as Jean Imbs & Haroon Mumtaz & Morten Ravn & Hélène Rey, 2005. "PPP Strikes Back: Aggregation and the Real Exchange Rate," The Quarterly Journal of Economics, MIT Press, vol. 120(1), pages 1-43, January.
Handle: RePEc:nbr:nberwo:9372
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