Long Swings In The Exchange Rate And The Excess Returns Puzzle: The Role Of Imperfect Knowledge

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of goods and services is the foundation for
the equilibrating dynamic. Behind the flow of goods and services is the gap
between the gap between, domestic and foreign short-term rates, and the steady
state long-run interest rate gap that sets goods flows to zero. The assumption
is that the prices of the domestic and foreign goods in their respective for-
eign currencies are "incorrect" based on the fundamentals of the respective
countries and that agents know this (and know that the exchange rate path is
unstable) but cannot be sure of the de-gree of "incorrectness" or the
persistence of the di vergence. Embedded into this model are as-sumptions about
PPP that provide comfort about this benchmark's ability to give the "correct"
relative prices. It is possible that these assumptions, to some degree, mask
the complexity of the situation with respect to PPP's ability to proxy relative
prices. At the theoretical level, PPP should simply offer equal purchasing
power for equal ...

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