The Adjustment of Prices and the Adjustment of the Exchange Rate

Charles Engel and James Morley

No 8550, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: The purchasing power parity puzzle relates to the adjustment of real exchange rates. Real exchange rates are extremely volatile, suggesting that temporary shocks emanate from the monetary sector. But the half-life of real exchange rate deviations is extremely large -- 2.5 to 5 years. This half-life seems too large to be explained by the slow adjustment of nominal prices. We offer a different interpretation. We maintain that nominal exchange rates and prices need not converge at the same rate, as is implicit in rational-expectations sticky-price models of the exchange rate. Evidence from an unobserved components model for nominal prices and nominal exchange rates that imposes relative purchasing power parity in the long run indicates that nominal exchange rates converge much more slowly than nominal prices. The real puzzle is why nominal exchange rates converge so slowly.

JEL-codes: F3 F4 (search for similar items in EconPapers)
Date: 2001-10
New Economics Papers: this item is included in nep-cba and nep-ifn
Note: IFM
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Citations: View citations in EconPapers (58)

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Related works:
Working Paper: The Adjustment of Prices and the Adjustment of the Exchange Rate (2000)
Working Paper: The Adjustment of Prices and the Adjustment of the Exchange Rate (2000)
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