A reappraisal of the evidence on PPP: a systematic investigation into MA roots in panel unit root tests and their implications |
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Authors: | Christoph Fischer Daniel Porath |
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Institution: | (1) Institute for Advanced Studies, Stumpergasse 56, 1060 Vienna, Austria |
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Abstract: | Panel unit root tests of real exchange rates—as opposed to univariate tests—usually reject non-stationarity. These tests,
however, could be biased if the real exchange rate contained MA roots. Indeed, two independent arguments claim that the real
exchange rate, being a sum of a stationary and a non-stationary component, is possibly an ARIMA (1, 1, 1) process. Monte Carlo
simulations show how systematic changes in the parameters of the components, of the test equation and of the correlation matrix
affect the size of first and second-generation panel unit root tests. Two components of the real exchange rate—the real exchange
rate of a single good and a weighted sum of relative prices—are constructed from the data for a panel of countries. Computation
of the relevant parameters reveals that panel unit root tests of the real exchange rate are severely oversized, usually much
more so than simple augmented Dickey-Fuller tests. Thus, the evidence for purchasing power parity from first and second-generation
panel unit root tests may be merely due to extreme size biases. |
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