A re-examination on dissecting the purchasing power parity puzzle

The purpose of this paper is to examine the source of a real exchange-rate adjustment based on the impulse-response function constructed from local projections when the true data-generating process (DGP) is unknown. This work extends the local-projection method proposed by Jorda [2005. Estimation and inference of impulse responses by local projections. American Economic Review 95, 161-182] to allow for variables that are I(1) and exhibit cointegration. Our paper shows that nominal exchange-rate adjustments dominate in the reversion toward PPP regardless of a nominal exchange-rate shock or a price shock. It is also shown that the half-life of real exchange rates is close to that of nominal exchange rates. Since these results are consistent with those of Cheung et al. [Cheung, Y.W., Lai, K.S., Bergman, M., 2004. Dissecting the PPP puzzle: the unconventional roles of nominal exchange rate and price adjustments. Journal of International Economics 64, 135-150], we therefore conclude that their main findings are robust to possible misspecifications in the true DGP. (C) 2011 Elsevier Ltd. All rights reserved.