Market frictions and real exchange rates

One explanation for the failure of purchasing power parity (PPP) is that market frictions impede trade, allowing departures from PPP to grow quite large without precipitating goods arbitrage. If this explanation is correct, then other things equal, large deviations from PPP should be less persistent than small differences. This paper examines this prediction over the modern floating-rate era. The outcome is surprising: between most countries, large deviations from PPP appear to be at least 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.