ABSTRACT
As discussed in Sections 2.1 and 2.2 of the previous chapter, there seems to have emerged a consensus in the literature that PPP is inadequate as a description of recent exchange rate changes in the short run. Several explanations are put forward for the observed short-run departures from PPP. One is the role of sectoral relative prices as an important channel for real factors to affect exchange rates. In this chapter we re-examine the case for changes in relative prices causing deviations from parity using an approach quite different from those found in the previous literature. Rather than using proxies for the prices, we use the Divisia price variance. This variance is a summary measure of changes in the relative prices of a broad basket of commodities. Consequently, it is likely to be a more satisfactory reflection of changes in real factors than the relative price of traded goods which has been used in previous research (see, for example, Clements and Frenkel 1980).
