“Parity Convergence of Real Exchange Rates: What Role Does Price Adjustment Play?” by Yin-Wong CHEUNG
Kon S. LAI
The conventional view, as expounded by sticky-price models, is that price adjustment governs the reversion process toward purchasing power parity (PPP). Researchers have been puzzled because the empirical reversion rate appears too slow to be explained by price adjustment. What role does price adjustment really play? This study measures the individual contributions of price and exchange rate adjustments and shows that the reversion dynamics at both short and long horizons are driven mostly by exchange rate adjustment, not price adjustment. Also, exchange rate adjustment tends to amplify and prolong PPP deviations. PPP reversion thus exhibits dynamics substantially different from that suggested by standard exchange rate models.