Adjustment Speeds of Nominal Exchange Rates and Prices toward Purchasing Power Parity

First draft: September 28, 2005The conventional view, as expounded by sticky-price models, is that price adjustment determines the PPP reversion rate. Contrary to this, recent studies indicate that nominal exchange rates converge much more slowly to PPP than nominal prices. This paper investigates how adjustment speeds of nominal exchange rates and prices toward PPP are affected by exchange rate regimes by employing a vector error correction model (VECM). We find evidence from 22 OECD countries that the adjustment speed of nominal exchange rates toward PPP is faster than that of prices as nominal exchange rates are relatively stable. This suggests that nominal exchange rate volatility has significant bearings on the variables primarily driving adjustment toward the long-run equilibrium level defined by PPP. We also show that the real exchange rates converge faster to the long-run PPP level for the relatively stable exchange rates, consistent with the evidence to support the significant mean reversion of real exchange rates for the gold standard period.21 p