A prominent question in international macroeconomics is why real exchange rates exhibit persistent deviations from purchasing power parity. Table 1 reiterates the basic findings of the preceding literature, using quarterly data for 1973-1997. 1 Averaging over countries, the onequarter autocorrelation is about 0.8, and that over four quarters is 0.27. 2 A related time-series literature concludes that the real exchange rate may be even more persistent. 3 In addition, the table shows the real exchange rate is quite volatile, with a standard deviation between four to five times that of output on average.Sticky prices are one explanation commonly offered for these real exchange rate movements. Monetary shocks could induce an immediate change in the nominal exchange rate, and this would translate into a change in the real exchange rate if national price levels remain fixed. Intertemporal models presenting this general view include Svensson and van Wijnbergen (1989), Obstfeld andKollmann (1996).A second explanation focuses on pricing-to-market, in which a firm intentionally sets different prices for its good across segmented national markets. 4 This explanation is consistent with empirical work by Engel (1993), Knetter (1993) and others, which have documented 4 The table closely resembles standard findings in the real business cycle literature: see Backus, Kehoe, and Kydland (1992), Chari, Kehoe and McGrattan (1998a), and Chang and Devereux (1998).5 All data are logged and Hodrick-Prescott filtered quarterly series. The real exchange rate is computed as the CPI-adjusted bilateral exchange rate with the U.S. dollar. If we do not Hodrick-Prescott filter the real exchange rate data, the average serial correlation naturally is much higher: 0.94 for one quarter and 0.71 for four quarters.6 See Froot and Rogoff (1995) for a summary of the time series literature. Several studies suggest real exchange rate deviations have a half-life of about four to five years. Some studies, such as Engel (1999), cast doubt on whether the real exchange rate is even mean reverting.7 A related explanation for deviations from the law of one price, suggested in Devereux (1997), is that prices are sticky in the local currency of the buyer.