“Aggregation Bias ” DOES Explain the PPP Puzzle∗

This article summarizes our views on the role of an "aggregation bias" in explaining the PPP Puzzle, in response to the several papers recently written in reaction to our initial contribution. We discuss in particular the criticisms of Imbs, Mumtaz, Ravn and Rey (2002) presented in Chen and Engel (2005). We show that their contentions are based on: (i) analytical counter-examples which are not empirically relevant; (ii) simulation re-sults minimizing the extent of "aggregation bias"; (iii) unfounded claims on the impact of measurement errors on our results; and (iv) problematic implementation of small-sample bias corrections. We conclude, as in our original paper, that "aggregation bias " goes a long way towards explaining the PPP puzzle. ∗This article is a sequel to our paper "PPP Strikes Back: Aggregation and the Real Ex-change Rate " (NBER WP December 2002, final version February 2005) and summarizes the material in Imbs, Mumtaz, Ravn and Rey (2003). Without implicating them, we thank Manuel Arellano, Lutz Kilian, Hashem Pesaran and Ron Smith for very helpful discussions. Some of the work on aggregation bias was realized when Imbs and Rey visited the IMF Re-search Department whose wonderful hospitality is gratefully acknowledged. This paper does not represent the views of the Bank of England or of Monetary Policy Committee members, and was partly written while Mumtaz was at London Business School.