Aggregation is not the solution: the PPP puzzle strikes back

M. Dolores Gadea and Laura Mayoral
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M. Dolores Gadea: University of Zaragoza, Spain, Postal: University of Zaragoza, Spain
Laura Mayoral: Institute for Economic Analysis (CSIC), Barcelona, Spain, Postal: Institute for Economic Analysis (CSIC), Barcelona, Spain

Journal of Applied Econometrics, 2009, vol. 24, issue 6, pages 875-894

Abstract: Recently, Imbs, Mumtaz, Ravn and Rey (2005, hereinafter IMRR) have argued that much of the purchasing power parity (PPP) puzzle is due to upwardly biased estimates of persistence. According to them, the source of the bias is the existence of heterogeneous price adjustment dynamics at the sectoral level that established time series or panel data methods fail to control for. This paper re-examines this claim in two steps. Firstly, we demonstrate that IMRR's measures of sectoral persistence are systematically downwardly biased because they are based on an inaccurate definition of the 'average' impulse response function (IRF). We then show that standard estimates of shock persistence are recovered after this bias is corrected. Secondly, building on the results in Mayoral (2008), which prove that aggregate and micro models induce the same shock persistence behavior, we show that estimates based on aggregate and sectoral exchange rates are, in fact, highly consistent. Thus, aggregation is not the solution to the PPP puzzle. Copyright © 2009 John Wiley & Sons, Ltd.

Date: 2009

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