A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings

Roman Frydman, Michael Goldberg, Soren Johansen () and Katarina Juselius
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Roman Frydman: New York University
Michael Goldberg: University of New Hampshire

No 08-31, Discussion Papers from University of Copenhagen. Department of Economics

Abstract: Asset prices undergo long swings that revolve around benchmark levels. In currency markets, fluctuations involve real exchange rates that are highly persistent and that move in near-parallel fashion with nominal rates. The inability to explain these two regularities with one model has been called the "Purchasing Power Parity puzzle". In this paper, we trace the puzzle to exchange rate modelers' use of the "Rational Expectations Hypothesis". We show that once imperfect knowledge is recognized, a monetary model is able to account for the puzzle, as well as other salient features of the data, including the long-swings behavior of exchange rates.

Keywords: PPP puzzle; long swings; imperfect knowledge; rational expectations hypothesis (search for similar items in EconPapers)
JEL-codes: F31 F41 G15 G17 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-knm, nep-mon and nep-opm
Date: 2008-12
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Related works:
Working Paper: A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings (2009)
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