Jacques J. Polak

English

Research Papers in Economics

476
IMF Staff Papers
Vol. 53, No. 3
© 2006 International Monetary Fund
476
IMF Staff Papers
Vol. 53, No. 3
© 2007 International Monetary Fund
Parity Reversion in Real Exchange Rates:  
A Puzzle or a Nonissue?
JACquES J. POLAk*
T
he attempt by Cashin and McDermott (2006) to “test the validity” of the pur-
chasing power parity (PPP) theorem by means of a refined measurement of the 
turnaround time of changes in real exchange rates calls for a brief comment. Their 
article, “Parity Reversion in Real Exchange Rates: Fast, Slow, or Not at All,” 
appeared in IMF Staff Papers, Volume 53, Number 1.
Ever since Rogoff’s (1996) seminal paper, this subject has flourished under the 
name of the “PPP puzzle,” which Rogoff defined as follows: “How is it possible to 
reconcile the extremely high short-term volatility of real exchange rates with the 
glacial rate (15 percent per year) at which deviations from PPP seem to die out?” 
(p. 664). Rogoff’s analysis starts out from the grandfather of PPP, the law of one 
price (LOP), which, as he states, holds mainly in the breach. He concludes by sug-
gesting an explanation of the PPP puzzle that runs entirely in terms of the impedi-
ments to the working of the LOP.
“It is simply this: international goods markets, though becoming more integrated 
all the time, remain quite segmented, with large trading frictions across a broad range 
of goods. These frictions may be due to transportation costs, threatened or actual 
tariffs, nontariff barriers, information costs, or lack of labor mobility” (p. 665). Rogoff 
closes his paper with the admission that “[t]his is not an entirely comfortable conclu-
sion, but for now there is no really satisfactory alternative explanation to the purchas-
ing power parity puzzle.”
I would agree that trading frictions is where one should look for an explanation 
of the failure of prices of individual commodities to converge across borders. But one 
*The author was the Director of the IMF Research Department from 1958–79. He thanks Paul Cashin 
for criticism of an earlier version of this note.PARIty REVERSIOn In REAL EXChAnGE RAtES: A PuzzLE OR A nOnISSuE?
477
has to look elsewhere for an explanation of a failure of price indices, such as PPP, to 
revert: at the mechanism that brings about—or does not bring about—balance of pay-
ments equilibrium.1
A change in a country’s price level is one of the factors that influences the cur-
rent account of its balance of payments. But (1) the magnitude of the impact is not 
easy to determine in advance; (2) it takes time for the full impact to materialize, 
including the time taken by the J-curve; (3) changes in demand and supply factors, 
and in macroeconomic policies, also affect the current account; (4) changes in the 
capital account codetermine the overall balance of payments outcome; (5) countries 
generally prefer riding out moderately sized changes in their overall balances of 
payments on their foreign exchange reserves to taking immediate corrective action; 
and (6) countries tend to respond more slowly to balance of payments surpluses 
than to balance of payments deficits.
The six factors listed readily explain the fact that national current account 
imbalances, and the underlying deviations of national price levels from what 
appeared to be PPP equilibrium rates, frequently continue for years and indeed 
decades. They also explain why in a substantial number of categories of cases—
which may well account for one-half of all potential observations—there is no 
ground for the expectation that any observed change in a country’s actual PPP will 
be followed by a reversal:
•  if the observed change is equilibrating;
•  if the observed change is equilibrium-neutral, in the sense that it accompanies a 
simultaneous and corresponding change in the demand and supply factors (the 
Balassa-Samuelson effect would be an example);
•  if the observed change is smaller than a certain minimum value which the country 
has learned to take in its stride.
These brief comments lead to four conclusions:
1.  The bulleted cases do not imply that relative prices do not affect the economy; 
they are merely instances in which PPP reversal is unlikely to occur except by 
chance.
2.  Trawling observations of changes in real exchange rates without allowing for the 
effect of changes in demand and supply factors and policy measures is not an 
efficient way to measure some kind of average PPP adjustment period across 
countries and time.
3.  Since, even for the same country, the period of PPP reversal in those instances 
where adjustment is expected to occur depends on a wide range of policy and 
market factors, I would question whether attempts at measuring a “typical” 
adjustment period for a particular country are worth the effort.
1This is by no means an original observation. It is found as a common theme in the international eco-
nomic literature of the 1920s and 1930s, as part of the rejection of Cassel’s more extreme versions of pur-
chasing power parity. See, for example, Angell (1922), Terborgh (1926), and Viner (1937). A citation from 
Viner (p. 385): “But the divergences between actual exchange rates and those required by the purchasing 
power parity formula are in fact frequently substantial, and the ‘disturbances’ from which such divergences 
result need not by any means be temporary in character, so that a longer period would lessen the divergence, 
but may in fact be progressive in character though time.”Jacques J. Polak
478
4.  A much more promising approach to understanding movements in real exchange 
rates is to relate them to real changes in the economy, as for example in Chen 
and Rogoff (2002), dealing with the experience of Australia, Canada, and New 
Zealand, and Cashin, Cespedes, and Sahay (2004), dealing with developing 
countries.
REFERENCES
Angell, James W., 1922, “International Trade Under Inconvertible Paper,” The Quarterly Journal 
of Economics, Vol. 36, No. 3, pp. 359–412.
Cashin, Paul, Luis F. Cespedes, and Ratna Sahay, 2004, “Commodity Currencies and the Real 
Exchange Rate,” Journal of Development Economics, Vol. 75, pp. 239–68.
Cashin, Paul, and C. John McDermott, 2006, “Parity Reversion in Real Exchange Rates: Fast, 
Slow or Not at All,” IMF Staff Papers, Vol. 53, No.1, pp. 64–89.
Chen, Yu-chin, and Kenneth S. Rogoff, 2002, Commodity Currencies and Empirical Exchange 
Rate Puzzles, IMF Working Paper 02/27 (Washington: International Monetary Fund).
Rogoff, Kenneth S., 1996, “The Purchasing Power Parity Puzzle,” Journal of Economic Literature, 
Vol. 34, pp. 647–68.
Terborgh, G.W., 1926, “The Purchasing-Power Parity Theory,” Journal of Political Economy, 
Vol. 34, No. 2, pp. 197–208.
Viner, Jacob, 1937, Studies in the Theory of International Trade (New York/London: Harper and 
Brothers).

Parity Reversion in Real Exchange Rates: A Puzzle or a Nonissue?

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