Purchasing Power Parity and Real Exchange Rates: Do Productivity Trends and Fiscal Policy Matter?

We present empirical evidence on the purchasing power parity hypothesis using a new data set from the late 19 th century for a number of major currencies. We confirm the results of previous empirical studies which show that the simple PPP hypothesis does not hold even over long time horizons, whilst extending these results to a larger set of countries. We use structural VAR models to show that persistent deviations from PPP are attributable to productivity differentials (the Balassa-Samuelson hypothesis). and divergences in fiscal policies. Fiscal policy shocks are shown to have only a temporary impact on the real exchange rate.