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.     

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.     

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.     

Modeling International Long-Term Interest Rates

This study investigates the relationship among interest rates on the long-term government bonds of five industrialized countries. Both standard and new unit root tests are applied, all of which confirm the presence of exactly one unit root. New cointegration tests are also applied to these data. In contrast to previous research on short-term bonds, stock prices, and exchange rates, these results find little evidence of cointegration among the five long-term interest rate series. Thus, when modeling or forecasting these central government long-term bond yields, one may assume separate sets of fundamentals and difference the data to achieve stationarity. An error correction model may not be appropriate.     

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.     

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.     

Searching for evidence of long-run PPP from a post-Bretton Woods panel: separating the wheat from the chaff

This paper reexamines the issue of long-run PPP using multiple panel tests in the framework of confirmatory analysis. Application of six panel tests under competing null hypotheses to the real exchange rates of 21 industrial countries yields seemingly contradictory evidence on the parity during the post-Bretton Woods period. Regardless of numeraire currency, four I(1) panel tests unanimously reject the null hypothesis in favor of long-run PPP, whereas two I(0) panel tests lend little support to the parity at conventional significance levels. Confirmatory analysis suggests that this puzzling result can be explained either by nonlinear dynamics of the real exchange rates or by a mixture of I(0) and I(1) series in the panel. Monte Carlo experiments indicate that potential mix of I(0) and I(1) series is more relevant to the empirical finding. The use of a sequential classification method sorts out six real exchange rates which exhibit most persistent deviations from long-run equilibrium. Systematic behavior of these series can be characterized better by country specific factors than by observable macroeconomic variables.     

Long-run PPP in a system context: No favorable evidence after all for the U.S., Germany, and Japan

In a cointegration analysis of PPP in five-variable system for Germany, Japan, and the U.S., Sideris [Sideris, D., 2006. Testing for long-run PPP in a system context: evidence for the U.S., Germany and Japan. Journal of International Financial Markets, Institutions and Money 16, 143–154] reports three cointegration vectors and concludes that they are consistent with some form of PPP for all three exchange rates. The present paper reconsiders Sideris's three-country analysis with special attention to the specification of deterministic terms in the cointegration testing. In addition, the passage of time since the Sideris paper allows the data set to be extended. The present paper also applies the Johansen approach and longer data set to traditional two-country models for the same exchange rates. In no case is any evidence in favor of PPP found.     

Trade concentration, openness, and deviations from purchasing power parity

Economists have often explained deviations from PPP in terms of random relative price changes. While all countries are subject to such real shock, empirical studies indicate that PPP seems to hold closer for some countries than others. This paper emphasizes two major reasons why we should expect systematic differences across countries in deviations from PPP: (a) the concentration of trade and (b) openness. The more diversified trade, the less susceptible the country to random shocks affecting individual goods, so that shifts in the PPP ratio are lower. The more open the economy, the greater the weight of traded goods in the overall price indices, so that if exchange rates are determined by traded goods prices, yet empirical tests of PPP use national price indices, PPP should hold better in more open economies.     

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.     

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.     

A Fractional Cointegration Approach to Testing Mean Reversion Between Spot and Forward Exchange Rates: A Case of High Frequency Data with Low Frequency Dynamics

This paper applies a relatively new but generalised concept of fractional cointegration to shed some light on the validity of a long-run relationship between high frequency daily spot and the lagged forward Australian-US dollar exchange rate. An investigation of the stochastic properties of these rates reveals that, while the relationship is not cointegrated in their logs, they appear to be fractionally cointegrated if we allow for mean reverting processes that are CI (1, d ) with 0< d <1. The paper demonstrates that relaxing the condition that the residual from the cointegration equation must be a I (0) process, captures a much wider class of mean-reversion behaviour. This result is interpreted in the context of the speculative EMH between the spot and forward exchanges rates, as having some empirical support. Furthermore, an analysis of the short-run dynamics propelling the long-run relationship tends to imply that in both the short- and long-term, the forward rate is led by the spot rate. In the longer term, the spot rate is found to be the initial receptor of any exogenous shock to the equilibrium and it is the forward exchange rate that bears the brunt of short-run adjustment to re-establish the long-run equilibrium relationship. The approach illustrated in this paper is shown to hold enormous potential for tests of mean reversion involving hypotheses popular to financial econometrics in general, where the dynamics of high frequency data are under scrutiny.     

Is the relationship between prices and exchange rates homogeneous?

Empirical tests of purchasing power parity (PPP) are implicitly based on the conditions of symmetry and proportionality of the price coefficients. We investigate a separate condition, which we term homogeneity. Specifically, while there may be factors that drive a wedge between prices and exchange rates, when these factors are held constant we would expect a change in exchange rates to be associated with a proportional, or homogeneous, change in prices. To test for the existence of homogeneity in prices, we conduct two experiments. First, we apply a time-varying-coefficient procedure to nine euro-area countries as well as the euro area as a whole during the (monthly) sample period, 1999:M1 to 2011:M3. Second we apply the same procedure to the same group of countries, plus Canada, Japan and Mexico, over the longer period, 1957:M4 to 2011:M3. We find that averages of the price coefficients, corrected for specification biases, are uniformly homogeneous in the long run, providing strong support 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.     

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.     

Valuation effects and long-run real exchange rate dynamics

This paper uses the Johansen test for cointegration to check the prediction of a portfolio balance model that predictable valuation effects are associated with a saddle-path dynamic relationship between the net foreign asset position and the real exchange rate. The analysis uses newly constructed quarterly series on the net foreign position as a percentage of the nominal gross domestic product, together with data on real effective exchange rate indices for a sample of developed countries which borrow in their own currency. The results indicate that the net foreign asset position and the real exchange rate are not cointegrated for all the countries in the sample. The rejection of saddle-path dynamics suggests that predictable valuation effects are quantitatively small in developed countries. The rejection of cointegration suggests that the net foreign asset position is not a determinant for long-run real exchange rates in developed countries.     

Testing PPP Hypotheses between Japan and the Six G7 Countries

The paper examines the purchasing power parity(PPP) theory of the foreign exchange rate of the yenagainst the currencies of the six G7 countries. We usethe error-corrected five-dimensional vectorautoregressive (VAR) model with structural changes inthe trend function. The data cover the period of thepost-Breton–Woods floating exchange rate system. Theresults reveal that the PPP relation alone determinesthe exchange rates for the USA, France, Germany, andItaly, while a linear combination of PPP and uncoveredinterest rate parity (UIP) relations determines that for Canada. Ina model without trend breaks, the PPP relations holdonly for Germany, which indicates that a correctspecification of the sampling distribution of data isimportant. The one-step prediction based on the errorcorrection model (ECM) outperforms the random walkmodel. The ECM is useful to predict the out-of-samplebehaviors of the exchange rates.     

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.     

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.     

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.