Purchasing power parity and the real exchange rate

DISCUSSION PAPER SERIES

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No. 2913

PURCHASING POWER PARITY

AND THE REAL EXCHANGE RATE

Lucio Sarno and Mark P Taylor

ISSN 0265-8003

PURCHASING POWER PARITY

AND THE REAL EXCHANGE RATE

Lucio Sarno, Warwick Business School and CEPR

Mark P Taylor, Warwick Business School and CEPR

Discussion Paper No. 2913

August 2001

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CEPR Discussion Paper No. 2913

August 2001

ABSTRACT

Purchasing Power Parity and the Real Exchange Rate*

We assess the progress made by the profession in understanding real

exchange rate behaviour, through a selective and critical but nonetheless

expository review of the literature. Our reading of the literature leads us to the

main conclusions that purchasing power parity might be viewed as a valid

long-run international parity condition when applied to bilateral exchange rates

among major industrialized countries and that mean reversion in real

exchange rates displays significant non-linearities. Further work investigating

the effects of real shocks on the long-run equilibrium level also seems

warranted.

JEL Classification: F31

Keywords: foreign exchange, purchasing power parity and real exchange rate

Lucio Sarno

Department of Finance

Warwick Business School

University of Warwick

Coventry

CV4 7AL

Tel: (44 24) 7652 8219

Fax: (44 24) 7657 2871

Email:

lucio.sarno@warwick.ac.uk

For further Discussion Papers by this author see:

www.cepr.org/pubs/new-dps/dplist.asp?authorid=138519

Mark P Taylor

Department of Finance

Warwick Business School

University of Warwick

Coventry

CV4 7AL

Tel: (44 24) 7657 3008

Fax: (44 24) 7652 3032

Email:

mark.taylor@wbs.warwick.ac.uk

For further Discussion Papers by this author see:

www.cepr.org/pubs/new-dps/dplist.asp?authorid=100357

* This Paper is forthcoming in the International Monetary Fund Staff Papers

and was partly written while Lucio Sarno was a Visiting Scholar at the Federal

Reserve Bank of St Louis. The authors are grateful to Bob Flood (editor), two

anonymous referees and Jim Lothian for constructive criticisms and

comments on a previous version of this Paper. Any remaining errors are

solely the responsibility of the authors.

NON-TECHNICAL SUMMARY

The purchasing power parity (PPP) exchange rate is the exchange rate

between two currencies which would equate the two relevant national price

levels if expressed in a common currency at that rate, so that the purchasing

power of a unit of one currency would be the same in both economies. This

concept of PPP is often termed absolute PPP. Relative PPP is said to hold

when the rate of depreciation of one currency relative to another matches the

difference in aggregate price inflation between the two countries concerned. If

the nominal exchange rate is defined simply as the price of one currency in

terms of another, then the real exchange rate is the nominal exchange rate

adjusted for relative national price level differences. When PPP holds, the

real exchange rate is a constant, so that movements in the real exchange rate

represent deviations from PPP. Hence, a discussion of the real exchange rate

is tantamount to a discussion of PPP.

Although the term ‘purchasing power parity’ was coined as recently as eighty

years ago (Cassel, 1918), it has a very much longer history in economics.

While very few contemporary economists would hold that PPP holds

continuously in the real world, ‘most instinctively believe in some variant of

purchasing power parity as an anchor for long-run real exchange rates’

(Rogoff, 1996), and indeed the implication or assumption of much reasoning in

international macroeconomics is that some form of PPP holds at least as a

long-run relationship. Moreover, estimates of PPP exchange rates are

important for practical purposes such as determining the degree of

misalignment of the nominal exchange rate and the appropriate policy

response, the setting of exchange rate parities, and the international

comparison of national income levels. It is not surprising, therefore, that a

large literature on PPP, both academic and policy related, has evolved.

This Paper summarizes the present authors’ reading of recent research on

PPP and real exchange rates – what we have learned and what the agenda is

for future research. Within the vast literature on PPP and real exchange rates,

professional opinion concerning the validity of PPP between the currencies of

the major industrialized countries, in both the short and long run, appears to

have shifted several times in the post-war period. If there is an emerging

consensus at the present time, it is probably reverting towards the view that

long-run PPP does have some validity, at least for the major exchange rates,

although a number of puzzles have yet to be resolved conclusively.

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