Price level convergence and purchasing power divergence

Abstract

We construct four large data sets of bilateral real exchange rates based on traded good prices (food and clothing, respectively) and broader price indices (consumer price index, CPI, and wholesale price index, WPI). On these data sets, we run non-parametric regressions to examine how the real exchange rate, the price differential, and the nominal exchange rate react to an overvalued real exchange rate over time. In line with the theory we develop, our regressions show the following: First, real exchange rates are mean-reverting. Second, prices converge. Third, price convergence implies purchasing power divergence and thus does not contribute to real exchange rate convergence. Indeed, when price adjustment is fast (as for our traded good price data sets), we even observe diverging nominal exchange rates. Our findings suggest that movements both away from and towards PPP may be less related to traded good price movements than is commonly thought.