This paper addresses the Purchasing Power Parity (PPP) puzzle for a commodity currency. In particular, we analyze the real exchange rate behavior in Norway, which has a primary commodity (oil) that constitutes the majority of its exports. A substantial part of the literature on commodity currencies has found that, despite controlling for the effect of commodity prices, PPP does not hold in the long run. We show that once we also control for the effect of the interest rate differential in the real exchange rate relationship, the deviations from PPP are fully accounted for. Furthermore, with the interest rate differential included in the long run real exchange rate relationship, the real oil price plays only a minor role. Adjustment to equilibrium (half-lives) is also substantially reduced, taking no more than one year on average. Hence, contrary to earlier findings on commodity currencies, this paper has effectively dealt with the PPP puzzle.
Economic theory typically predicts that the behavior of the real exchange rate should be closely related to the behavior of deviations from Purchasing Power Parity (PPP). However, ever since Meese and Rogoff (1983) reported that a comprehensive range of exchange rate models were unable to outperform a random walk, the role of economic fundamentals in explaining exchange rate behavior has been scrutinized. There is now a widespread agreement that substantial deviations from PPP have occurred since the abandonment of the Bretton Woods fixed exchange rate system in 1971. In particular, time series studies for this period have shown that the real exchange rate is not only very volatile in the short run; the speed of convergence to PPP in the long run is extremely slow, (see, e.g., Froot and Rogoff, 1995; and Rogoff, 1996 for a survey).
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