Deviations from purchasing power parity under different exchange rate regimes: Do they revert and, if so, how?

We propose an empirical model for deviations from long-run purchasing power parity (PPP) that simultaneously accounts for three key features: (i) adjustment toward PPP may occur via nominal exchange rates and relative prices at different speeds; (ii) different exchange rate regimes may generate regime shifts in the structural dynamics of PPP deviations; (iii) nonlinear reversion toward PPP in response to shocks. This empirical framework encompasses and synthesizes much previous empirical research. Using over a century of data for the G5 countries, we provide evidence that long-run PPP holds, the relative importance of nominal exchange rates and prices in restoring PPP varies over time and across different exchange rate regimes, and reversion to PPP occurs nonlinearly, at a speed that is fairly consistent with the nominal rigidities suggested by conventional open economy models. (c) 2006 Elsevier B.V. All rights reserved.