Aggregation and the PPP Puzzle in a Sticky-Price Model

Carvalho, Carlos; Nechio, Fernanda

doi:10.1257/aer.101.6.2391

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American Economic Review: Vol. 101 No. 6 (October 2011)

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Aggregation and the PPP Puzzle in a Sticky-Price Model

Article Citation

Carvalho, Carlos, and Fernanda Nechio. 2011. "Aggregation and the PPP Puzzle in a Sticky-Price Model." American Economic Review, 101(6): 2391-2424.

DOI: 10.1257/aer.101.6.2391

Abstract

We study the purchasing power parity (PPP) puzzle in a multisector, two-country, sticky-price model. Sectors differ in the extent of price stickiness, leading to heterogeneous sectoral real exchange rate dynamics. Deviations from PPP are more volatile and persistent than in an otherwise identical one-sector world economy with the same average frequency of price changes. Under the empirical distribution of price stickiness of the US economy, the model produces PPP deviations with a half-life of 39 months. We provide a structural interpretation of the approaches found in the empirical literature on aggregation and PPP, and reconcile its apparently conflicting findings. (JEL F31, G31)

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Authors

Carvalho, Carlos (Pontifical Catholic U Rio de Janeiro)
Nechio, Fernanda (Federal Reserve Bank of San Francisco)

JEL Classifications

F31: Foreign Exchange
G31: Capital Budgeting; Fixed Investment and Inventory Studies; Capacity