The Adjustment of Prices and the Adjustment of the Exchange Rate

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 halflife 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 unobserved components models for nominal prices and nominal exchange rates that impose 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. Engel acknowledges research support from a National Science Foundation grant to the National Bureau of Economic Research.