Handbook of Exchange Rates

7.6 Conclusion and Implications

This chapter has surveyed the empirical evidence on the properties of deviations from the LOP and PPP for tradable goods. While it is fair to say that a universal consensus may not exist yet, the emerging consensus at the present time is converging toward the view that deviations from the LOP are transitory and therefore the LOP holds in the long run among a broad range of tradable goods and currencies.

In our view, a promising strand of research that goes some way toward understanding the behavior of LOP deviations is the literature that has investigated the role of nonlinearities in the adjustment toward the long-run equilibrium implied by the LOP (Obstfeld and Taylor, 1997; Sarno et al., 2004; Blavy and Juvenal, 2009). For example, Sarno et al. (2004) provide evidence of nonlinear reversion toward the LOP in a number of major sectoral exchange rates during the post-Bretton Woods period. However, they also provide evidence of price stickiness and heterogeneity across goods and currencies, as one would expect.

While it would be overly simplistic to believe that all that drives exchange rates is goods prices, the empirical evidence surveyed here suggests that the LOP is at least a good first approximation to the link between exchange rates and goods prices across countries. Put another way, if price differentials of individual goods do not converge to the same number over time (once expressed in the same currency), the drift must be small enough ...