Getting PPP right: Identifying mean-reverting real exchange rates in panels

Recent advances in testing for the validity of Purchasing Power Parity (PPP) focus on the time series properties of real exchange rates in panel frameworks. One weakness of such tests, however, is that they fail to inform the researcher as to which cross-section units are stationary. As a consequence, a reservation for PPP analyses based on such tests is that a small number of real exchange rates in a given panel may drive the results. In this paper we examine the PPP hypothesis focusing on the stationarity of the real exchange rates in up to 25 OECD countries. We introduce a methodology that when applied to a set of established panel unit-root tests, allows the identification of the real exchange rates that are stationary. Our results reveal evidence of mean-reversion that is significantly stronger as compared to that obtained by the existing literature, strengthening the case for PPP.     

Why panel tests of purchasing power parity should allow for heterogeneous mean reversion

Recent studies of purchasing power parity (PPP) use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates. In contrast to several other severe restrictions of panel models and tests of PPP, the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. This paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies. Using Monte Carlo simulation, we uncover important adverse properties of the panel approach that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. These properties can lead to misleading inferences on the validity of PPP. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.     

Purchasing power parity, unit roots, and dynamic structure

Recent studies of purchasing power parity (PPP) account for the possible presence of unit roots in nominal exchange rates and relative price indices by applying standard unit-root tests to real exchange rates, which are ratios of nominal exchange rates and relative price indices. These studies occasionally find evidence of PPP, but as a whole, the evidence is not definitive. Standard unit-root tests impose a restrictive dynamic structure between nominal exchange rates and relative price indices. I specify and estimate a generalized dynamic structure. I reject the dynamic restrictions implicit in standard unit-root tests of PPP, and find stronger evidence of PPP than do most other recent studies.     

Testing the Purchasing Power Parity Hypothesis for the New Member and Candidate Countries of the European Union: Evidence from Lagrange Multiplier Unit Root Tests with Structural Breaks

This paper investigates the validity of purchasing power parity (PPP) for the eleven Central and East European transition countries and three market economy countries, Cyprus, Malta, and Turkey. Unlike previous studies on PPP, this study uses Lagrange multiplier (LM) unit root tests that incorporate structural breaks in the data series. The findings indicate that in cases of one and two structural breaks, for a U.S. dollar-based real exchange rate series, there is little evidence supporting the validity of PPP. For a deutsche mark-based real exchange rate series, for the cases of both one and two breaks, there is evidence of stationarity of real exchange rates for eight sample countries, which is consistent with PPP. The results also indicate that the estimated half-life of a shock to the real exchange rate ranges from 1.25 (15.05 months) to 2.72 (32.72 months) years across countries. The empirical findings may provide direction for policy makers to coordinate monetary policies for the process of European monetary integration.     

Long-run purchasing power parity,prices and exchange rates in transition: The case of six Central and East European countries

This paper presents empirical results on the hypothesis of long-run purchasing power parity (PPP) with respect to the exchange-rate regimes in six Central and East European countries. The analysis employs cointegration theory to examine the movements of prices and exchange rates in transition to a market economy. Our results are based on system estimation procedures developed by Stock and Watson (1993) and Johansen (1991). We find moderate evidence to support long-run equilibria, however, the cointegrating vector values do not yield to easy interpretation and violate the symmetry and proportionality conditions suggested by PPP. We provide an explanation for such behavior and find that it is consistent with the existing literature on transition and foreign exchange markets.     

Deviations from purchasing power parity under different exchange rate regimes: Do they revert and,if so,how?

We propose an empirical model for deviations from long-run purchasing power parity (PPP) that simultaneously accounts for three key features: (i) adjustment toward PPP may occur via nominal exchange rates and relative prices at different speeds; (ii) different exchange rate regimes may generate regime shifts in the structural dynamics of PPP deviations; (iii) nonlinear reversion toward PPP in response to shocks. This empirical framework encompasses and synthesizes much previous empirical research. Using over a century of data for the G5 countries, we provide evidence that long-run PPP holds, the relative importance of nominal exchange rates and prices in restoring PPP varies over time and across different exchange rate regimes, and reversion to PPP occurs nonlinearly, at a speed that is fairly consistent with the nominal rigidities suggested by conventional open economy models.     

Purchasing power parity in ASEAN-5 countries: revisit with cross-sectional dependence and structural breaks

This paper re-examines the purchasing power parity (PPP) hypothesis for a panel of ASEAN-5 countries. The panel unit root and cointegration tests, which incorporate cross-sectional dependence and multiple structural breaks, are innovatively used for testing the PPP hypothesis. We could not find evidence that supports the existence of a long-run equilibrium between the relative price ratio and the nominal exchange rate for the whole period. Nevertheless, there is evidence of a cointegrating relationship for the post-crisis period. Our finding implies that a flexible exchange rate regime is suitable for the individual ASEAN countries.     

Temporal aggregation and purchasing power parity persistence

This paper uses a unique new monthly US-UK real exchange rate series for the January 1794-December 2009 period to reexamine the academic debate over purchasing power parity (PPP). The consensus view described by Rogoff (1996) is that PPP holds in the long-run, but short-run deviations are very persistent, with half-lives ranging from 3 to 5 years. Most of the literature using long time series relies on the annual data developed by Lee (1976) and Lothian and Taylor (1996), which were both constructed from underlying higher-frequency data sources. Estimates of purchasing power parity persistence using these series may therefore be subject to temporal aggregation bias. We find evidence of aggregation bias which indicates the half-life of PPP deviations has been overestimated in much of the previous literature. We also find that estimates of the half-lives are further reduced once we account for the Harrod (1933)-Balassa (1964)-Samuelson (1964) effect. The result of aggregation bias appears to be robust even when considering the case that real exchange rates exhibit nonlinear dynamics.     

A test of purchasing power parity for emerging economies

The concept of purchasing power parity (PPP) is examined here for its applicability to the soft currencies of a large group of emerging/developing economies. PPP is tested through the use of the technique of cointegration. Based on data covering the period of 1975–1997, cointegration tests of price indices and exchange rates are conducted for 27 countries (against the U. S.). The results provide relatively strong evidence (for 14 countries) in favor of the long-term applicability of PPP as a cointegration concept. Further tests on real exchange rates indicate that the symmetry and proportionality conditions implied by PPP are rejected in all but one case. The latter tests also show that departures from long-term exchange values can last for several years and that a priori restrictions imposed on the cointegrating vector can lead to a false rejection of the PPP concept.     

Post Bretton Woods deviations from purchasing power parity in G7 exchange rates—an empirical exploration

Exchange rates have deviated substantially and idiosyncratically from purchasing power parity (PPP) since the breakdown of Bretton Woods. In this paper, a model incorporating both traditional PPP and financial market variables is constructed and tested on the US dollar's six G7 exchange rates during the floating rate era. Empirical tests show that the model's common set of variables—with consistent signs—can explain the divergent behavior of G7 exchange rates during 1973.2–90.2. Idiosyncracies are reflected in different subsets of the model's variables entering significantly into each exchange rate's regression; the existence of stable relationships is demonstrated by the equations' co-integration.