Menu Costs and Nonlinear Reversion to Purchasing Power Parity among Developed Countries

Abstract

ABSTRACT: This paper examines the implications of menu cost models for the rate of reversion to purchasing power parity. Recent menu cost models (Ball and Mankiw, 1994) imply that higher inflation is correlated with more rapid price adjustment. This means that reversion to PPP may be more rapid, the greater the rate of inflation. In order to test this proposition, PPI-deflated real exchange rates are examined to see if the rate of reversion to PPP is a function of inflation. Another implication, due to both Delgado (1991) and Greenwald and Stiglitz (1989), is that higher exchange rate volatility is associated with slower rates of reversion. I find that both of these propositions hold in panel data, although the second proposition is less robust

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