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VECM estimations of the PPP reversion rate revisited: the conventional role of relative price adjustment restored

  • Kim, Hyeongwoo

Cheung et al. (2004) use a vector error correction model (VECM) for the current float nominal exchange rate and the relative price data and claim that the sluggish Purchasing Power Parity (PPP) reversion is primarily driven by the nominal exchange rate, not by relative price adjustment, which is at odds with the conventional sticky-price models. Our major findings are as follows. First, we suggest cases where VECMs are of limited usefulness even when all the variables in the system are not weakly exogenous. Second, using century-long exchange rates, we find that the relative price plays an important role for PPP reversion when real shocks occur. Third, protracted hump-shaped responses of real exchange rates are frequently observed when there is a relative price shock, leading to sluggish adjustments toward PPP. Nominal exchange rate shocks generate humped dynamics much less frequently.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 33005.

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Date of creation: Aug 2011
Date of revision:
Handle: RePEc:pra:mprapa:33005
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  1. Pesaran, H. Hashem & Shin, Yongcheol, 1998. "Generalized impulse response analysis in linear multivariate models," Economics Letters, Elsevier, vol. 58(1), pages 17-29, January.
  2. V.V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2000. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," NBER Working Papers 7869, National Bureau of Economic Research, Inc.
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  4. Pesaran, M. Hashem & Shin, Yongcheol, 1996. "Cointegration and speed of convergence to equilibrium," Journal of Econometrics, Elsevier, vol. 71(1-2), pages 117-143.
  5. Alan M. Taylor, 2002. "A Century Of Purchasing-Power Parity," The Review of Economics and Statistics, MIT Press, vol. 84(1), pages 139-150, February.
  6. Hyeongwoo, Kim, 2009. "Generalized Impulse Response Analysis: General or Extreme?," MPRA Paper 17014, University Library of Munich, Germany.
  7. Jon Steinsson, 2005. "The Dynamic Behavior of the Real Exchange Rate in Sticky Price Models," Economics wp28_jonst, Department of Economics, Central bank of Iceland.
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  9. Froot, Kenneth A. & Rogoff, Kenneth, 1995. "Perspectives on PPP and long-run real exchange rates," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 32, pages 1647-1688 Elsevier.
  10. Claude Lopez & Christian J. Murray & David H. Papell, 2004. "State of the Art Unit Root Tests and Purchasing Power Parity," University of Cincinnati, Economics Working Papers Series 2004-04, University of Cincinnati, Department of Economics.
  11. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  12. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  13. 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.
  14. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," Center for International and Development Economics Research, Working Paper Series qt0sx02651, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
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  16. Elliott, Graham & Rothenberg, Thomas J & Stock, James H, 1996. "Efficient Tests for an Autoregressive Unit Root," Econometrica, Econometric Society, vol. 64(4), pages 813-36, July.
  17. Alan M. Taylor, 2000. "Potential Pitfalls for the Purchasing-Power-Parity Puzzle? Sampling and Specification Biases in Mean-Reversion Tests of the Law of One Price," NBER Working Papers 7577, National Bureau of Economic Research, Inc.
  18. Serena Ng & Pierre Perron, 2001. "LAG Length Selection and the Construction of Unit Root Tests with Good Size and Power," Econometrica, Econometric Society, vol. 69(6), pages 1519-1554, November.
  19. Charles Engel, 2000. "Comments on Obstfeld and Rogoff's "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?"," NBER Working Papers 7818, National Bureau of Economic Research, Inc.
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