Equilibrium exchange rate: Purchasing Power Parity (PPP) Reconsidered

Equilibrium exchange rate

Equilibrium exchange rate: Fundamental Equilibrium Exchange Rate

Equilibrium exchange rate: Behavioral Equilibrium Exchange Rate

Equilibrium exchange rate: Natural Real Exchange Rate

Equilibrium exchange rate: New Open Economy Macroeconomic Class of Models

Equilibrium exchange rate: Other Approaches

The equilibrium measure thatmany economists and policymakers first turn to is the concept of purchasing power parity (PPP).The PPP exchange rate is the ratio of some overall measure of domestic prices relative to a comparable measure of foreign prices. Although there is controversy in the PPP literature regarding the correctmeasure of overall prices to use (e.g., consumer, wholesale, or some other measure) there is no longer a question about the ‘‘time dimension’’ of PPP. By this we mean how quickly exchange rates are expected to gravitate, or revert, to the PPP defined rate (MacDonald 2007).

Proponents of traditional PPP would argue that disturbances to PPP should be rapidly offset. But howrapidly should this be to be consistentwithPPP? The classic disturbance that affects the relationship between the nominal exchange rate and relative prices is a liquidity disturbance, such as a monetary expansion. The latter, in the context of an economy in which there are sticky commodity prices, will not have an immediate effect on relative prices butwould have their effect 18 months to 2 years thereafter. In this setting, therefore, a monetary shock is expected to move the real exchange rate in the short run, but the real exchange rate should revert to itsmean value after around two years: a proponent of traditional PPP would argue that the so-called half-life of mean reversion would be one year.

There is now a huge empirical literature that indicates that the so-called half-life has a range of between three and five years, which is inconsistent with a traditional formof PPP;Rogoff (1996) labeled this the PPP puzzle. It is a puzzle because the stylized fact of the high volatility of real and nominal exchange rates is consistent with the interaction of liquidity shocks with sticky prices, but as we have seen, the slow mean reversion of real exchange rates is not.

Various attempts have been made to explain the PPP puzzle. One explanation, which is consistent with traditional PPP, is that the existence of transaction costs imparts a nonlinear process to exchange rate behavior, and when such nonlinear behavior is accounted for, real exchange rates behave in amanner that is consistent with traditional PPP they have a half-life of around one year. Such nonlinear explanations, however, are really nothingmore than black box interpretations and are equally consistent with other interpretations of the PPP puzzle (MacDonald 2007). A second key explanation of the PPP puzzle, which is not consistent with traditional PPP, is that real factors, such as productivity differences (usually motivated in terms of the Balassa-Samuelson effect) and a country’s net foreign asset position, ultimately push real exchange rates away fromtheir equilibrium values. A third key explanation of the PPP puzzle is the pricing-to-market behavior of multinational firms. Such firms, by altering theirmarkup (in order to protect market share) as nominal exchange rates change, impart prolonged and persistent deviations from PPP. Although this latter view appears to capture an important determinant of the systematic behavior of real exchange rates, the second explanation may be more critical to understanding equilibrium exchange rates and, by implication, whether exchange rates are misaligned or not. We now consider these alternatives, all of which are based on an explicitly ‘‘real’’ interpretation of real exchange rate behavior.