A Resolution of the Purchasing Power Parity Puzzle : Imperfect Knowledge and Long Swings

Asset prices undergo long swings that revolve around benchmark levels. In currency markets, fluctuations involve real exchange rates that are highly persistent and that move in near-parallel fashion with nominal rates. The inability to explain these two regularities with one model has been called the quot;Purchasing Power Parity puzzlequot;. In this paper, we trace the puzzle to exchange rate modelers' use of the quot;Rational Expectations Hypothesisquot;. We show that once imperfect knowledge is recognized, a monetary model is able to account for the puzzle, as well as other salient features of the data, including the long-swings behavior of exchange rates