International real interest rate differentials, purchasing power parity and the behaviour of real exchange rates: the resolution of a conundrum

According to one strand of the international finance literature, market efficiency implies that the real exchange rate follows a martingale process, in direct conflict with the long-run absolute purchasing power parity hypothesis, which requires a stationary real exchange rate process. This conflict between market efficiency and long-run PPP appears as something of a conundrum. We resolve this conundrum by relaxing the assumption of a constant real interest rate differential and analysing the vector equilibrium correction system linking prices and the exchange rate, and draw out the economic intuition of our result. Copyright © 2004 John Wiley & Sons, Ltd.