The PPP Puzzle: What the Data Tell when Allowed to Speak Freely

The persistent movements away from long-run benchmark values in real exchange rates, dubbed the PPP puzzle, observed in many real exchange rates during periods of currency float have been subject to much empirical research without resolving the puzzle. The paper demonstrates how the cointegrated VAR approach by grouping together components of similar persistence can be used to uncover structures in the data that ultimately may help to explain theoretically the forces underlying such puzzling movements. The charaterization of the data into components which are empirically I(0), I(1), and I(2) is shown to be a powerful organizing principle allowing us to structure the data in long-run, medium-run, and short-run behavior. Its main advantage is the ability to associate persistent movements away from fundamental benchmark values in one variable/relation with similar persistent movements somewhere else in the economy.