The ‘real’ explanation of the PPP puzzle

ABSTRACT

This article shows that global financial markets cannot, by themselves, achieve net transfers of financial capital and real interest rate equalization across countries and that the integration of both global financial markets and global goods markets is needed to achieve net transfers of capital and real interest rate equalization across countries. Thus, frictions (barriers to mobility) in one or both of these markets can impede the net transfer of capital between countries, produce the Feldstein and Horioka (1980) finding of high-saving-investment correlations and prevent real interest rates from being equalized across countries. Moreover, frictions in global goods markets can explain why real exchange rates deviate from purchasing power parity (PPP) for extended periods of time and can therefore also explain the PPP puzzle. Consequently, we are able to resolve two of Obstfeld and Rogoff’s (2000) ‘6 major puzzles in macroeconomics’ with essentially the same explanation.

KEYWORDS:

• Exchange rate volatility
• Feldstein–Horioka paradox or puzzle
• PPP puzzle
• purchasing power parity puzzle
• real interest rate equalization
• real interest rate parity

JEL CLASSIFICATION:

• E40
• F21
• F31
• F32
• F36
• G15

Acknowledgements

The authors are indebted to Neil Gorman and Gerry Mulligan for their valuable advice and comments. This work was supported by JSPS (Japan Society for the Promotion of Science) KAKENHI Grant Number 15H01950, an Asian Growth Research Institute project grant and a grant from the MEXT Joint Usage/Research Center for Behavioral Economics, Institute of Social and Economic Research, Osaka University. Any remaining errors are the authors.

Disclosure statement

No potential conflict of interest was reported by the authors.

Additional information

Funding

This work was supported by JSPS (Japan Society for the Promotion of Science) KAKENHI Grant Number 15H01950, an Asian Growth Research Institute project grant and a grant from the MEXT Joint Usage/Research Center for Behavioral Economics, Institute of Social and Economic Research, Osaka University.