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

Abstract

Asset prices undergo long swings that revolve around benchmark levels. In currency markets, ‡uctuations involve real exchange rates that are highly persistent and that move in nearparallel 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.

Searching for a Theory that fits the Data: A Personal Research Odyssey

“…The deviations from both the PPP and the UIP conditions exhibited a pronounced persistence that was empirically indistinguishable from a …rst -or sometimes even second -order nonstationary process, whereas a combination of the two was often found to be stationary. This was precisely what early work on a monetary model for exchange rate determination based on imperfect knowledge expectations assumed would be the case (subsequently published in Goldberg, 2007, 2011). As a consequence, it became the beginning of a long collaboration between Roman and Michael on one hand and the econometrics group in Copenhagen on the other.…”

“…But, due to other demanding commitments, it took roughly 10 years until I …nalized the ideas in a chapter of the Handbook of Econometrics (Juselius, 2009b). Given the integration properties of the data, the paper demonstrated that a stationary PPP was empirically invalid, a result that was in accordance with the theory of imperfect knowledge economics Goldberg, 2007, 2011). That the PPP needs the UIP to become stationary was subsequently demonstrated in several papers.…”

“…In 1999 I was invited to give a presentation at a conference on "Macroeconomics and the Real World" held in Bertinoro. At that time I had been struggling to formulate a complete set of testable long-run hypotheses for a monetary model of in ‡ation (Friedman, 1970 andRomer, 1996). It was a perfect chance for presenting this idea, subsequently labelled a theory-consistent CVAR scenario.…”

Co‐integrating Var Models and Economic Policy

“…Frydman et al . (), solve the PPP puzzle by the use of the IKE hypothesis to explain the long swings in the exchange‐rate path.…”

“…As such, CVAR models are instruments that are well suited to confront theoretical results of Imperfect Knowledge Economics (Frydman and Goldberg, ) with empirical evidence (e.g. : Frydman et al ., , ).…”