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A solution for the PPP Puzzle of the persistence and volatility of real exchange rates

Page history last edited by Alex Backer, Ph.D. 9 months, 1 week ago Saved with comment
  • PPP Puzzle: The PPP puzzle, considered one of the two real exchange rate puzzles, concerns the observation that real exchange rates are both more volatile and more persistent than most models would suggest. The only clear way to understand this volatility would be to assign substantial roles to monetary and financial shocks. However, if shocks play such a large role the challenge becomes finding what source, if one even exists, of nominal rigidity that could be so persistent to explain the long-term prolonged nature of real exchange rate deviations.[1]

 

Solution:

1. Persistence is tied to an asymmetry in the direction of exchange rate fluctuations. The more rare currency typically only gets devalued.

2. That asymmetry is related to the asymmetry in demand for currencies. Demand for the more rare currency is more local --which contributes to the volatility, as there is no global marketplace to stabilize the exchange rate: the market is like a small sailing boat, not like a transatlantic ship; demand for the more common one (e.g. the USD) more global. This asymmetry makes demand for the rare currency more local and more limited, leading to:

3. Exchange rates are set locally by those in the smaller market, and more specifically their willingness to sell dollars to those providing the more rare currency. Thus, exchange rates are driven by supply-side economics. Without a strong demand, exchange rates never recover from fluctuations, explaining their persistence.

 

In any buy-sell transaction, the transaction may be initiated by either buyer or seller, and the price may be set by buyer or seller (seller- or buyer- driven pricing and transactions). These asymmetries, and more specifically any asymmetry in relative volumes of buyer- or seller-initiated transactions, can create an asymmetry in the prevalent directionality of price fluctuations. When most transactions are initiated by an Argentine resident trying to buy dollars with their pesos, for example, the price is set by the seller of dollars. One of two situations typically emerges:

1. The supply is large enough to meet demand, and the price stays constant, or

2. The supply is not large enough to meet demand, and prices rise

It's only when transactions become primarily driven by supply seeking to sell and supply exceeds demand that prices are likely to drop.

 

Ref 1. Obstfeld, MauriceRogoff, Kenneth (2000), "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?", in Bernanke, Ben; Rogoff, Kenneth (eds.), NBER Macroeconomics Annual 2000, vol. 15, The MIT Press, pp. 339–390, ISBN978-0-262-02503-4

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