MARKET FRICTIONS AND REAL EXCHANGE-RATES

One explanation for the failure of purchasing power parity (PPP) is th at market frictions impede trade, allowing departures from PPP to grow quite large without precipitating goods arbitrage. If this explanatio n is correct, then other things equal, large deviations from PPP shoul d be less persistent than small differences. This paper examines this prediction over the modern floating-rate era. The outcome is surprisin g: between most countries, large deviations from PPP appear to be at l east as persistent as small deviations, and perhaps even more so. The exceptions are for some intra-EC real exchange rates. The implication is that market frictions alone do not explain the chimerical nature of PPP. (C) 1998 Elsevier Science Ltd. All rights reserved.