A revisit on dissecting the PPP puzzle: Evidence from a nonlinear approach

The purpose of this paper is to re-investigate issues in purchasing power parity (PPP) convergence using a threshold vector error-correction model with deutschmark-based exchange rates. We find that the half-life of real exchange rates is less than two and a half years, that PPP convergence is attributed to nominal exchange rate adjustment for most countries, and that the half-life of nominal exchange rates is close to that of real rates and is longer than that of prices in general. Our findings are consistent with those of Cheung et al. [Cheung et al. 2004, Journal of International Economics 64, 135-150] except that our estimated half lives of real and nominal exchange rates are much shorter than theirs. These findings are important since they explain the PPP puzzle and indicate the significance of a nonlinear model in examining the engine of PPP convergence.