International real interest rate differentials, purchasing power parity and the behaviour of real exchange rates: The resolution of a conundrum

According to one strand of the international finance literature, market efficiency implies that the real exchange rate follows a martingale process, in direct conflict with the long-run absolute purchasing power parity hypothesis, which requires a stationary real exchange rate process. This conflict between market efficiency and long-run PPP appears as something of a conundrum. We resolve this conundrum by relaxing the assumption of a constant real interest rate differential and analysing the vector equilibrium correction system linking prices and the exchange rate, and draw out the economic intuition of our result. Copyright (C) 2004 John Wiley Sons, Ltd