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Economics Research Institute Study Paper




Utah State University Department of Economics

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The literature on the purchasing power parity (PPP) theory reports that all versions of the PPP theory do badly in explaining exchange rate movements in terms of changes in national price levels. If purchasing power parity holds true, the real exchange rate remains constant over time. The negative empirical results point to the failure of PPP. This paper contends that if the equilibrium real exchange rate has shifted over time due to real shocks, then what is interpreted as the failure of the PPP may not actually be so. This paper investigates the issue and econometric tests indicate that the variable trend/cointegration implication is broadly consistent with the quarterly movements of bilateral exchange rates for the period 1973Ql to 1993Q4 between the U.S. and other countries like Germany, Japan, U.K., and Switzerland. One implication of this study is that it can serve as a benchmark for determining the limits of the band of target zone models.