This chapter presents an overview of the long-run determinants of purchasing power parity (PPP). It reviews the huge time series literature testing simple PPP. This area has proven fruitful ground for applying modern methods for dealing with nonstationary and near-nonstationary time series. The chapter traces out the evolution of the literature from naive static tests of PPP to modern unit-root approaches for testing whether real exchange rates are stationary and to cointegration techniques—the most recent phase of PPP testing. The research on more disaggregated price data is discussed in the chapter, including a nearly two-hundred year data set on commodity prices in England and France during the seventeenth and eighteenth centuries. Aside from providing an extremely long data set, this historical data offers some perspective on the behavior of cross-country relative prices in more modern times. The chapter looks at some possible medium- and long-run determinants of the real exchange rate, particularly the supply-side determinants emphasized in the popular Balassa–Samuelson model. It also considers some evidence that positive demand shocks, such as unexpected increases in government spending, lead to medium-run appreciations of the real exchange rate.
Edited by K. Froot, D. Crane, S. Mason, A. Perold, R. Merton, Z. Bodie, E. Sirri and P. Tufano, Boston: Harvard Business School Press, 1995, Chapter 7, 225-261. (Revised from Harvard Business School Working Paper no. 95-020.)
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