Testing deviations from purchasing power parity

This paper studies analytically how the presence of transportation costs in a model of deviations from purchasing power parity (PPP) affects the testing procedure of the PPP hypothesis. The analysis shows that in the presence of transportation costs traditional regression analysis will tend to reject the PPP hypothesis even if goods markets are well arbitraged, because the values of the regression coefficients are affected systematically by considerations that are independent of the degree to which markets are arbitraged. Thus, the content of the PPP approach cannot be tested satisfactorily without considering the systematic effects of transportation costs and other costs of goods arbitrage.     

Money shocks and deviations from purchasing power parity

This paper applies the island-economy framework of Phelps (1970) to a small open economy under a flexible exchange rate to study the effects of nominal (and real) disturbances on the purchasing power parity relation. Incomplete information about the aggregate state of the economy (and informational differences between agents) implies that a monetary shock that has finite variance can induce deviations from purchasing power parity while also affecting production, consumption and the current account. The real effects of money, however, become smaller as the variance of money gets larger. A type of ‘Lucas slope effect’ of money on deviations from purchasing power parity is obtained.     

Relative price changes and deviations from purchasing power parity

During recent years, exchange rate fluctuations have exceeded variation in price indices. As a result, a number of theories have been developed to explain the apparent ‘overshooting’ of the exchange rate. The purpose of this paper is to argue that such elaborate extensions may be unnecessary, because the law of one price is more robust than previously believed. In particular, it can be shown that the law of one price is consistent with the observed variability of exchange rates and that it outperforms the overshooting models in explaining the stochastic behavior of exchange rates and interest rates.     

Measuring the persistence of deviations from purchasing power parity with a fractionally integrated STAR model

Empirically, elements of both fractional long memory and threshold non-linearity are present in the real exchange rates of the G-7 countries against the US, notably in the EU countries. Estimated half lives of deviations from PPP using median unbiased corrections to conventional linear autoregressive models corroborate existing evidence related to the PPP paradox as half lives range from at least four years to an infinite number of years. In contrast, for each EU country, accounting for threshold non-linearity results in estimated half lives that can be less than three years even with the allowance for fractional long memory.     

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.     

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.     

Static deviations from purchasing-power parity

The paper examines the ‘real’ effects of monetary policy in a small open economy in full stock-flow equilibrium. In the presence of government debt, an increase in the money supply generally produces deviations from purchasing power parity. Money creation through foreign-exchange purchases results in an overvaluation of the domestic currency. While its short-run effects favor the export industries, its long-run effects are thus in favor of the domestic sector. The same is true for open-market purchases, but the overvaluation is probably smaller in this case.     

A re-examination on dissecting the purchasing power parity puzzle

The purpose of this paper is to examine the source of a real exchange-rate adjustment based on the impulse-response function constructed from local projections when the true data-generating process (DGP) is unknown. This work extends the local-projection method proposed by Jordà [2005. Estimation and inference of impulse responses by local projections. American Economic Review 95, 161-182] to allow for variables that are I(1) and exhibit cointegration. Our paper shows that nominal exchange-rate adjustments dominate in the reversion toward PPP regardless of a nominal exchange-rate shock or a price shock. It is also shown that the half-life of real exchange rates is close to that of nominal exchange rates. Since these results are consistent with those of Cheung et al. [Cheung, Y.W., Lai, K.S., Bergman, M., 2004. Dissecting the PPP puzzle: the unconventional roles of nominal exchange rate and price adjustments. Journal of International Economics 64, 135-150], we therefore conclude that their main findings are robust to possible misspecifications in the true DGP.     

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.     

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.     

A century of purchasing power parity confirmed: The role of nonlinearity

Taylor (2002) claims that Purchasing Power Parity (PPP) has held over the 20th century based on strong evidence of stationary for century-long real exchange rates for 20 countries. Lopez et al. (2005), however, found much weaker evidence of PPP with alternative lag selection methods. We reevaluate Taylor’s claim by implementing a recently developed nonlinear unit root test by Park and Shintani (2005). We find strong evidence of nonlinear mean-reversion in real exchange rates that confirms Taylor’s claim. We also find a possible misspecification problem in using the ESTAR model that may not be detected with Taylor-approximation based tests.     

National price levels, purchasing power parity, and cointegration: a test of four high inflation economies

The time series properties of exchange rates and wholesale prices from four high inflation countries show some evidence in support of purchasing power parity. Tests for stationarity of real exchange rates and cointegration among price and exchange rate variables are presented for Argentina, Brazil, Chile, and Israel during the 1970s and 1980s. Error correction models describe the mechanism of adjustment to long-run equilibrium.     

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.     

Beyond the purchasing power parity: testing for cointegration and causality between exchange rates, prices, and interest rates

This paper reexamines the causality between the dollar and the yen in a multivariate framework with the aid of cointegration and error-correcting modeling for the 1951–94 period. The Phillips-Perron tests and Johansen's tests are performed. While causality from interest rates to exchange rates is found in the short run, no causality between prices and exchange rates is found in the short run. However, causality is found running from relative prices to exchange rates along with interest rates between the U.S. and Japan in the long run, which supports the long-run PPP hypothesis.     

A sequential purchasing power parity test for panels of large cross-sections and implications for investors

In this paper we use monthly time series data for not less than 64 countries and a new sequential approach to test for purchasing power parity (PPP). The results are strong in that the evidence in favor of PPP is very weak. In fact, for the US-dollar-based exchange rates the evidence is basically non-existent. In order to eliminate the effect of the base currency, we also apply the sequential PPP test to all pairs of exchange rates, and find similarly weak evidence of PPP. However, for those rates where evidence is found, using a technical trading rule, we find evidence of significant profits. The predictability of the stationary pairs is therefore important for investors.     

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.     

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.     

Culture, openness, and finance

Differences in culture, proxied by differences in religion and language, cannot be ignored when examining why investor protection differs across countries. We show that a country's principal religion predicts the cross-sectional variation in creditor rights better than a country's natural openness to international trade, its language, its income per capita, or the origin of its legal system. Catholic countries protect the rights of creditors less well than Protestant countries. A country's natural openness to international trade mitigates the influence of religion on creditor rights. Culture proxies are also helpful in understanding how investor rights are enforced across countries.     

Purchasing power parity: Modeling and testing mean reversion

A model of mean reversion of exchange rates to purchasing power parity is developed and tested where exchange rates are assumed to follow a mean reverting elastic random walk toward a stochastic PPP rate. The model recognizes the possibility that mean reversion towards PPP may be nonlinear which allows greater flexibility in the adjustment process. Regression equations consistent with the theoretical model are derived. The model is tested using long- and short-term data for six countries. While the results are generally consistent with the findings of previous studies, evidence is presented which demonstrates that the mean reversion process is not linear for some countries.