A managerial model of investment: overlooked alternatives

The long-run purchasing power parity (PPP) hypothesis is tested for nine bilateral sterling exchange rates, using recently developed techniques on cointegration and seasonal integration. The empirical findings show that none of the exchange rates and relative prices contain seasonal unit roots, but all have an autoregressive unit root. The cointegration tests overwhelmingly reject the PPP hypothesis as a long-run equilibrium condition for all countries concerned.     

An empirical examination of long-run purchasing power parity as theory of international commodity arbitrage

An empirical analysis of long-run purchasing power parity (PPP) as a theory of international commodity arbitrage between UK and US prices and the sterling/US dollar exchange rate for the period 1975–1980 is presented. Econometric techniques concerning the cointegration of economic time series are applied to a sample of 35 manufactured commodities which in 1977 constituted approximately a quarter of the net output of all manufacturing industry in Great Britain. Our results are extremely unfavourable to the PPP hypothesis as a stable long-run proportionality between exchange rates and disaggregated prices.     

Purchasing Power Parity When Prices Are I(2)

This paper examines the purchasing power parity (PPP) hypothesis over the modern float using data on 15 OECD currencies. Evidence is presented that suggests the price levels evolve as second-difference stationary processes, i.e., integrated of order two ( P₁– I (2)). A necessary condition for PPP when prices are I (2) is that prices are cointegrated across countries to an I (1) relative price. In general this relative price is not the same as the simple price ratio. For some of the relationships examined, this relative price level is cointegrated with the exchange rate, implying a long-run equilibrium between nominal exchange rates and prices.     

Fractional cointegration,low frequency dynamics and long-run purchasing power parity: an analysis of the Australian dollar over its recent float

A relatively new but generalized concept of fractional cointegration is applied to shed some light on the validity of purchasing power parity (PPP) as a long-run equilibrium condition, by examining the long-run relationship between quarterly consumer price indices and bilateral exchange rates of the Australian dollar and seven major OECD trading partners, over Australia's recent float. The paper demonstrates that relaxing the condition that the residual from the cointegration equation must be a I(0) process, provides a wide range of cases of parity-reversion with processes that are CI(1,d) with 0 < d < 1. Findings tend to suggest that, while standard tests of cointegration fail to support cointegration between nominal exchange rates, domestic and foreign prices, and thus the empirical favour for PPP as a long-run phenomenon, the fractional cointegration analysis permits deviations from equilibrium to follow a fractionally integrated process and hence captures a much wider class of parity or mean-reversion behaviour. Results are mainly supportive of long-run PPP. Furthermore, an analysis of the short-run dynamics propelling the long-run relationship (through a VECM) reveals that domestic prices are consistently the initial receptor of an exogenous shock to the equilibrium and the long-run equilibrium is restored through the short-run adjustment of the nominal exchange rates. These findings are shown to hold clear policy implications.     

Testing a theoretical model of mortgage demand on UK data

This study explores whether the long-run purchasing power parity (PPP) hypothesis holds for selected real exchange rates from Turkish economy during the period 1982M1–2003M12. In addition to conventional unit root tests, five different unit root test procedures have been applied including efficient point-optimal tests, extended M tests and GLS-detrended variants of DF tests, to four monthly real exchange rate series defined in terms of both producer and consumer price indices. The countries analysed are the USA, the UK, Germany and Italy which are major trade partners of Turkey. Mixed evidence is found for the long-run PPP hypothesis when real exchange rate is defined in terms of German DM and Italian Lira. However, the empirical analysis reveals that the PPP hypothesis holds strongly in the long-run for the UK£ and US$ based real exchange rates series using either PPI or CPI. In corroboration with other studies in the literature, the bias correlated half-life estimates suggest relatively faster speeds of adjustment supporting the view that the deviations from the PPP rate dissipate rather quickly for relatively high inflation countries.     

Removal of farm subsidies in a regional economy: a computable general equilibrium analysis

There are a number of studies that examine the purchasing power parity (PPP) hypothesis. The empirical findings from the extant literature for the PPP hypothesis are mixed. This article applies univariate and panel Lagrange Multiplier (LM) unit root tests with one and two structural breaks to real exchange rates for 15 Asian countries. The univariate LM unit root tests find evidence of PPP for two-thirds of the sample. The results from the panel LM unit root test support long-run PPP for the Asian countries in the sample. The results from the LM panel unit root tests differ from those of existing panel unit root tests of PPP for Asian countries that have not allowed for the existence of structural breaks.     

Long memory and mean reversion in real exchange rates in Latin America

This article examines the long-run Purchasing Power Parity (PPP) hypothesis for 12 Latin American Real Effective Exchange Rates (REERs) using fractional integration techniques. The empirical results, applying parametric approaches, provide evidence of mean reversion in the REERs in the cases of Nicaragua, Belize, Costa Rica, Guyana and Paraguay and lack of it for the remaining seven countries. Employing semiparametric methods, the evidence of mean reversion covers the following countries: Belize, the Dominican Republic, Ecuador and Mexico. Thus, only for Belize and Guyana do we obtain consistent evidence of mean reversion in the real exchange rates. At the other extreme, lack of mean reversion, and thus, lack of PPP, is obtained with both methods in Bolivia, Brazil, Colombia and Venezuela. For the remaining six countries, the results are ambiguous. The results for the PPP theory in Belize and Guyana may show the importance of promoting policies based on exchange rate flexibility and economic liberalization to reach a long-run stability scenario that leads to greater international competitiveness and lower external vulnerability.     

The Balassa-Samuelson Model: A General-Equilibrium Appraisal*

We derive two key propositions of the Balassa-Samuelson model as long-run balanced growth implications of a neoclassical general equilibrium model. the propositions are that productivity differentials determine international differences in nontradable relative prices and deviations from PPP reflect differences in nontradable prices. Closed-form solutions are obtained and tested using panel methods applied to long-run components of OECD sectoral data computed using the Hodrick-Prescott filter. the results indicate that labor productivity differentials help explain international low-frequency differences in relative prices. However, predicted nontradable relative prices are less successful in explaining long-run deviations from PPP. Unless very sophisticated indeed, PPP is a misleadingly pretentious doctrine, promising us what is rare in economics, detailed numerical predictions. (Paul A. Samuelson, 1964, p. 153)     

Purchasing power parity revisited: evidence from old and new tests for an organisation for economic co-operation and development panel

The objective of this article is to study long-run Purchasing Power Parity (PPP) for a panel of 21 Organisation for Economic Co-operation and Development (OECD) countries from the end of the Bretton Woods era by applying a wide range of the econometric techniques available. This will allow us to present a comprehensive up to date examination of the empirical validity of PPP, covering the weak and strong versions of the hypothesis with individual and panel analysis, including the absence or presence of cross-dependency, the linear or nonlinear behaviour of the real exchange rates and the degree of persistence. Overall, the results provide evidence in favour of PPP.     

Testing purchasing power parity in a multivariate cointegrating framework

This paper examines a bilateral PPP(Purchasing power parity) relationship between Australia and the 11 major trading countries by means of two alternative econometric techniques-a multivariate cointegrating framework and a band-spectral regression. It is acknowledged that there is no strong evidence that classical PPP holds in all cases. However, the generalized version of PPP holds in all cases, and provides a better explanation of the long-run relations between exchange rates and relative prices.The use of different price indices, i.e CPI and WPI,lead to different estimates and hence different policy implications.     

The Political Economy of Real Exchange Rate Behavior: Theory and Empirical Evidence for Developed and Developing Countries, 1960–2010

Empirical results of testing the PPP hypothesis have constantly shown that relative prices do not converge to the same level, either in the short or the long run. Therefore, the PPP explanation of the real exchange rate does not provide a reasonable measure of competitiveness at the international level. This article puts forth a different approach based on the works of Ricardo, Marx, Harrod and Shaikh. It argues that the real relative unit labor cost is the main factor explaining the long-run behavior of the real exchange rate. The second section of the article explains the theoretical underpinnings of our approach. The third section analyzes the role of the real interest rate differential in explaining real exchange rate misalignments. In the fourth section, we present a graphical analysis of the interrelation among the real effective exchange rate, the real unit labor cost ratio, the short-run real interest rate differential and the trade balance for 16 OECD countries, Taiwan and three developing countries for the period 1960–2010. The fifth section investigates the long-run relationship between the latter three indexes through co-integrating and error correction models using the ARDL–ECM framework. The last section provides our conclusions.     

Inflation targeting and real exchange rates: A bias correction approach

This paper examines whether inflation targeting (IT) influences purchasing power parity (PPP) by a bias correction approach under cross-sectional dependence. The recursive mean adjustment (RMA) method proposed by So and Shin (1999) and Shin and So (2001) is employed to correct a downward bias in half-life estimates of real exchange rates. More importantly, the empirical results show that IT lowers variability of real exchange rates and plays an important role in providing favorable evidence for long-run PPP.     

Testing the relative purchasing power parity hypothesis: the case of Korea

This study examines the relative purchasing power parity (PPP) hypothesis using the data from the Korean won–US dollar and the Korean won–Japanese yen foreign exchange markets. We extract proxies for inflation from stock market returns of Korea, the United States and Japan based on the method used by Chowdhry, Roll and Xia in 2005. We explicitly test the relative PPP hypothesis in light of the short-run price volatility using monthly, bimonthly and quarterly data from 1 January 1998 to 31 December 2012. Our findings suggest that the empirical test results from the entire sample period do not support the relative PPP hypothesis. However, the results from the sample period excluding the Asian Financial Crisis period show that the relative PPP hypothesis holds for the Korean won–US dollar market with a moderate magnitude of inflation impact, but not for the Korean won–Japanese yen market. Abrupt changes in exchange rates during the crisis period may have affected the relationship between inflation and exchange rates. This result also suggests that factors other than inflation might have affected the Korean won–Japanese yen exchange rate.     

Trade flows,relative prices,and effective exchange rates: a VAR on Ethiopian data

The dynamic response of trade flows to price and effective exchange rate changes is examined via VAR using quarerly data from Ethiopia for the period 1973(i)–1985(iv). The results show one-way Granger-causality running from prices and exchange rates to imports and exports without significant feedback. Imports and exports exhibit similar response patterns to unexpected changes in relative prices and exchange rates. The responses of imports and exports are larger and the adjustment takes longer when relative prices rather than exchange rates caused a change in international prices. In the long-run, changes in prices account for a larger percentage of the forecast error variances in imports and exports than exchange rate changes. It is shown that devaluation may have an initial adverse effect on the trade balance.     

A Test of Long-run Purchasing Power Parity Allowing for Structural Breaks*

If exchange rates and prices are integrated processes, standard econometric tests of the purchasing power parity (PPP) hypothesis may be biased towards rejection. This paper avoids this problem by using the Engle and Granger (1987) theory of cointegrated processes. If the absolute version of purchasing power parity is true, and nominal exchange rates and prices are integrated processes, inter-commodity arbitrage should ensure that the real exchange rate is stationary. The stationarity hypothesis is tested using Australian real exchange rate data for the 1890–1984 period We find that the effective real exchange rate cannot be modelled as a stationary process and therefore reject the absolute version of PPP. We also employ a test for structural breaks due to, for instance, the oil price shock and find mixed results. Another interpretation of our results is that the real exchange rate was affected by a series of permanent, real shocks during the sample period     

The long-run convergence of exchange rates and prices in the European Union

This paper provides tests of Purchasing Power Parity (PPP) for members of the EU-27 not in the euro area, using multivariate and panel cointegration techniques, for the period since the introduction of the euro currency in 1999 until the end of 2009. The results indicate that long-run PPP holds in ten cases and that domestic prices or the nominal exchange rate is the main driver of the short-run adjustment to stationarity. These results are discussed in terms of monetary convergence in the long-run.     

Measuring international competitiveness: experience from East Asia

This paper uses a new measure of real exchange rates as an indicator of international competitiveness. This new measure involves defining all prices and exchange rates on an appropriately weighted basket of currencies rather than a single currency. The measure is applied to the data for Japan, Korea, Thailand, Malaysia and Singapore. For comparison purposes, we calculate real exchange rates based on purchasing power parity (PPP) for these countries. To check for the relative performance of the two measures, cointegration tests are employed. The results indicate that the new measure tends to be closely related with the export growth for the sample countries, while the PPP-based measure is not. Moreover, the PPP-based real exchange rates tend to understate the measures of competitiveness for these countries. This result has important implications in terms of the levels of these countries' exchange rates as well as the well-known Balassa hypothesis.     

Cointegration,dynamic structure,and the validity of purchasing power parity in African countries

The purpose of this paper is to test the validity of the purchasing power parity (PPP) in Africa in the context of a multivariate error-correction model. This approach allows for the consideration of long-run elasticities as well as the dynamics of the short-run adjustment of exchange rates to changes in domestic and foreign prices. Monthly data for fourteen African countries are used, and the period examined is 1973:4 through 2007:7 (i.e., 412 observations). Results from long-run cointegration analysis, short-run error correction models, persistence profile analysis and variance decomposition all confirm the validity of PPP in these moderate-to-high inflation countries, where estimates of half-life deviations from PPP are found to be outside the range suggested by Rogoff (1996).     

Does PPP hold in the transition economies? The case of poland Hungary

This paper uses non-stationarity and cointegration of time series to investigate the validity of long-run purchasing power parity for Poland and Hungary for the period 1981:1-1993:2. Long-run PPP is examined vis-à-vis three countries, the United States, United Kingdom and Germany. Although the nominal exchange rates and relative price ratios between Poland and Hungary and each of the three countries are non-stationaary, they are not cointegrated indicating a rejection of the hypothesis. This conclusion is supported by the real exchange rate, which follows a random walk.     

Book Reviews

Abstract

This paper argues that exchange rate models rooted in the theory of Purchasing Power Parity (PPP) and balanced trade are fundamentally mis-specified, as evidenced by the disjuncture between: (1) the empirical evidence, which largely refutes PPP; and (2) the empirical result that ‘real’ productivity shocks are associated with observed secular trends in exchange rates. In the former case we have a theory without convincing evidence, and in the latter case we have empirical evidence in want of a consistent theory. If looked at from the perspective of a ‘cost of production’ theory of prices, such empirical results might not be so theoretically anomalous. So-called ‘real’ variables (especially productivity and unit labor costs), let in through the side door as ‘shocks’ to PPP equilibrium, may in fact be part and parcel of the formation of prices of production on an international scale through capitalist competition. The primary conclusion is that the empirical evidence supports a cost of production theory of the terms of trade and the real exchange rate. The empirical evidence in support of the Balassa–Samuelson model of the exchange rate is re-interpreted in this light. In this interpretation, parity holds only in terms of rates of return on investment which, in the classical tradition, are presumed to equalize across industries internationally.