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ch11 (4) - Two measures Speed of convergence how quickly...

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Two measures: Speed of convergence: how quickly deviations from PPP disappear over time (estimated to be 15% per year). Half-life: how long it takes for half of the deviations from PPP to disappear (estimated to be about four years). These estimates are useful for forecasting how long exchange rate adjustments will take. If a currency is undervalued or overvalued, then the real exchange rate is not equal to one at all times. We can allow for this by letting q change in the formulas we have derived. From the definition of q: If q=1 is constant (PPP) then the 1 st term on the right is zero. To forecast the change in E you just need to forecast the inflation differential, as before. If q deviates from 1, and we can measure it, then we can use the convergence speed to estimate how quickly q will rise/fall towards 1. This estimate of the rate of change of q can then be factored in, in addition to the inflation differential, to allow for an estimate of nominal depreciation.
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