The Micro-Macro Disconnect of Purchasing Power Parity

Authors

Paul R. Bergin

Jyh-Lin Wu

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2010-14 | May 1, 2010

The persistence of aggregate real exchange rates is a prominent puzzle, particularly since adjustment of international relative prices in microeconomic data is much faster. This paper finds that adjustment to the law of one price in disaggregated data is not just a faster version of the adjustment to purchasing power parity in the aggregate data; while aggregate real exchange rate adjustment works primarily through the foreign exchange market, adjustment in disaggregated data is a qualitatively distinct process, working through adjustment in local-currency goods prices. These distinct adjustment dynamics appear to arise from distinct classes of shocks generating macro and micro price deviations. A vector error correction model nesting aggregate and disaggregated relative prices permits identification of distinct macroeconomic and good-specific shocks. When half-lives are estimated conditional on shocks, the macro-micro disconnect puzzle disappears: microeconomic relative prices adjust to macro shocks just as slowly as do aggregate real exchange rates. These results provide evidence against theories of real exchange rate behavior based on sticky prices and on heterogeneity across goods.

Article Citation

Wu, Jyh-Lin, Paul R. Bergin, and Reuven Glick. 2010. “The Micro-Macro Disconnect of Purchasing Power Parity,” Federal Reserve Bank of San Francisco Working Paper 2010-14. Available at https://doi.org/10.24148/wp2010-14

About the Author
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Reuven Glick is a group vice president in the Economic Research Department of the Federal Reserve Bank of San Francisco. Learn more about Reuven Glick