Does Price Matter? A Re-examination of the PPP Debate

[[abstract]]This study re-examines whether and how the mean-reverting behavior of real exchange rates hinges upon the price indices selected in computing the real exchange rates. By employing the panel data of real exchange rates from 28 countries for the period 1971-2010, our unit root tests show that, in contrast to the findings of many previous studies, e.g., Coakley et al. (2005), the null of no mean-reverting is overwhelmingly rejected regardless of whether the real exchange rates are computed using consumer price indices (CPIs) or producer price indices (PPIs). However, our panel estimation of the error-correction model reveals that: (1) nominal exchange rates tend to respond to the misalignment of CPI-based real exchange rates but not PPI-based real exchange rates, and (2) the response of relative PPIs to the misalignment of PPI-based real exchange rates is much greater than the response of relative CPIs to the misalignment of CPI-based real exchange rates