The Perils of Using Aggregate Data in Real Exchange Rate Estimations
The rate of mean reversion in a country's real exchange rate (RER) is a key indicator to consider when discussing exchange rate policies in any country. In practice, this rate known as the half life is commonly calculated using price aggregates, such as the consumer price index (CPI) I demonstrate that using a CPI to estimate the RER mostly yields higher persistence estimates than a RER based on the disaggregated formula suggested by PPP theory. Using a novel dataset with a daily frequency of price collection and an identical set of products from multiple countries, I find that the half life for a RER derived from price aggregates is on average 37% higher than a RER generated from product level information. Until now estimates suggested that the rate of mean reversion was unreasonably slow, ranging from a minimum of 2 to 5 years. The sample used in this paper indicates that this rate is in fact typically less than 1 year. The dataset has been gathered from online sources and includes food, fuel, and electronic products.