An empirical examination of long-run purchasing power parity using cointegration techniques

This paper presents an empirical analysis of long-run purchasing power parity (PPP) for five major exchange rates using recently developed econometric techniques on the cointegration of economic time series. Our empirical results are extremely unfavourable to the PPP hypothesis as a long-run equilibrium condition, even with an allowance made for measurement error and/or tranportation costs. In particular, we are unable to reject the hypothesis of non-cointegration of the exchange rate and relative prices for any of the countries concerned. Far from finding a stable, long-run proportionality between exchange rates and relative prices, our results therefore suggest that they tend to drift apart without bound.     

Further evidence on purchasing power parity and country characteristics

Using data from 76 countries, this paper investigates the relationship between country characteristics and the validity of purchasing power parity (PPP). Several interesting results are obtained based on dollar-based exchange rates. First, PPP holds for Africa and Latin America. Further, PPP tends to be supported for countries with high or moderate openness, low growth rates, high inflation rates and high nominal exchange rate volatility, respectively. Second, a single country characteristic seems inadequate to account for the validity of PPP. Third, PPP is supported if countries satisfy at least two characteristics of supporting PPP simultaneously. Finally, the main results of the paper are robust when the numeraire currency changes from the US dollar to Japanese yen.     

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.     

Common trends in prices and exchange rates. Tests of long-run purchasing power parity

The empirical validity of long-run purchasing power parity is investigated using multi-variate cointegration techniques. Both bilateral and multilateral PPP is examined. The data set is monthly and covers almost 22 years (January 1970–August 1991) for four countries — Germany, Japan, the U.S., and Great Britain. While three cointegrating relations are detected among the set of nominal exchange rates and domestic price levels (or equivalently, there exists a reduced number of common stochastic trends) none of these satisfy the linear constraints implied by PPP. We conclude that neither bilateral nor multilateral PPP can be supported by the behavior of the data.     

Long-run purchasing power parity with asymmetric adjustment: Further evidence from nine transition countries

In this study, we applied a threshold cointegration test to investigate the properties of asymmetric adjustment on long-run purchasing power parity (PPP) in nine transition countries between January 1995 and December 2008. Although there was strong evidence of long-run PPP for these nine transition countries (i.e., Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, and Russia), the adjustment mechanism was asymmetric. These results have important policy implications for the nine transition countries included in the study.     

Examining the evidence of purchasing power parity by recursive mean adjustment

This paper revisits the empirical evidence of purchasing power parity under the current float by recursive mean adjustment (RMA) proposed by So and Shin (1999). We first report superior power of the RMA-based unit root test in finite samples relative to the conventional augmented Dickey–Fuller (ADF) test via Monte Carlo experiments for 16 linear and nonlinear autoregressive data generating processes. We find that the more powerful RMA-based unit root test rejects the null hypothesis of a unit root for 16 out of 20 current float real exchange rates relative to the US dollar, while the ADF test rejects only 5 at the 10% significance level. We also find that the computationally simple RMA-based asymptotic confidence interval can provide useful information regarding the half-life of the real exchange rate.     

Examining world-wide purchasing power parity

We examine long-run PPP between Germany, Great Britain, Japan and the United States over the period 1930–1996 using multivariate cointegration techniques. Bilateral PPP between the four countries is examined in one system (as opposed to e.g. series of trivariate systems). In all of the statistical analysis, asymptotic tests are augmented by parametric bootstrap analogues, whereby we reduce, if not eliminate, the size distortion typically present in small-sample studies. The cointegration analysis provides support for the necessary conditions for PPP (i.e. cointegrating relations are found) but not for the sufficient conditions (i.e., the coefficients in the cointegrating relations are far from what PPP predicts). These results are at odds with results from other studies that also analyze long-horizon data sets.First version received: November 2000/Final version received: February 2003Comments by Stefan Norrbin, Lee Ohanian, Anders Vredin, seminar-participants at Sveriges Riksbank (the central bank of Sweden) and at the Econometric Society European Meeting in Santiago de Compostela are gratefully acknowledged.     

Home bias and deviations from purchasing power parity

Empirical analysis has produced mixed results in testing for PPP. This note presents a simple model linking home bias towards home-produced tradable goods with deviations from absolute PPP. We show that this bias constitutes a significant determinant of PPP deviations.     

Ex ante purchasing power parity: Some evidence based on vector autoregressions in the time domain

Theex ante purchasing power parity (EPPP) hypothesis maintains that the expected rate of nominal exchange rate depreciation should be equal to the expected inflation differential over the relevant period. By modelling the inflation differential and the rate of depreciation as a jointly determined process, this paper derives a test of EPPP by examining the vector autoregressive representation. We also make allowance for the possibility of conditional heteroscedasticity in the inflation and exchange rate innovations. Our empirical results tend to support the EPPP hypothesis.Any views expressed are those of the author and are not necessarily those of the Bank of England. I am grateful to two anonymous referees and an editor for comments on a previous version of this paper; the usual disclaimer applies.     

Testing the purchasing power parity in panel data

This paper empirically tests the purchasing power parity (PPP) using panel unit root tests. We employ a battery of panel unit root tests: LM-bar statistic [Testing for unit roots in heterogeneous panels, Working paper, University of Cambridge] is employed to account for serially correlated errors. The statistic proposed by Breitung [Adv. Econom. 15 (2000) 161.] and the KPSS-based statistic of Hadri [Econ. J. 3 (2000) 148.] are also used. In addition, we also employ a SUR estimator to account for possible cross-sectional effect. Data of 45 economies from 1980 to 1999 are used to test the PPP hypothesis. We find that these estimators tend to get supportive results when the data frequency becomes lower, which substantially characterizes the long-run property of the PPP hypothesis.     

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.     

Some further evidence on the long-run neutrality of money

A recently developed reduced-form test for long-run neutrality is applied to twentieth-century Australian data on real output and the nominal money stock. The results show that narrowly defined money is neutral. However, real output is not invariant in the long run to a broader-based measure of the money stock.     

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.     

Sticky prices and purchasing power parity deviations: Empirical implications

This note tests one implication of the hypothesis that purchasing power parity (PPP) deviations are partly caused by different pricing behavior in goods and asset markets. Cross-country regressions of the variance of PPP deviations on the variance of money supply innovations support the hypothesis.     

Revisiting purchasing power parity for major OPEC countries: evidence based on nonlinear panel unit-root tests

In this study, we apply nonlinear panel unit-root test to assess the nonstationary properties of the real exchange rate for seven major Organization of the Petroleum Exporting Countries (OPEC). We find that nonlinear panel unit-root test has higher power than linear method suggested by Breuer et al. (2001 Breuer, J. B., McNown, R. and Wallace, M. S. 2001. Misleading inferences from panel unit-root tests with an illustration from purchasing power parity. Review of International Economics, 9: 482–93. [Crossref] , [Google Scholar]) if the true data generating process of exchange rate is in fact a stationary nonlinear process. We re-examine the validity of Purchasing Power Parity (PPP) from the panel nonlinear point of view and provide robust evidence clearly indicating that PPP holds true for four countries, namely Angola, Indonesia, Iran and Saudi Arabia. Our findings point out their exchange rate adjustment is mean reversion towards PPP equilibrium values in a nonlinear way.     

Buffer stocks,exchange rates and deviations from purchasing power parity

In this paper an extension of the Monetary Approach to the Exchange Rate reduced form is presented and estimated for four bilateral exchange rates with data from the recent floating experience. The extension incorporates two features: a more sophisticated modelling of money demand, using theCarr andDarby money demand specification, and allowing for deviations from purchasing power parity. The estimated results are supportive of our extended specification and we conclude by arguing that care should be taken in specifying the underlying structural relationships in asset reduced form exchange rate equations.     

Long-run purchasing power parity revisited: a Monte Carlo simulation

The existence of long-run purchasing power parity (PPP) implies that a cointegration vector of nominal exchange rate, domestic price, and foreign price is expected regardless of using the Engle-Granger two-step method or Johansen maximum likelihood approach. However, this paper has found conflicting results: the Engle-Granger technique tends to reject the long-run PPP hypothesis whereas the Johansen method is generally supportive of long-run PPP. Via Monte Carlo simulations, the present paper finds that the Johansen approach has a bias toward supporting long-run PPP especially under the circumstances in which the assumption of normally or/and independently and identically distributed disturbance terms is violated.     

On the deviations from purchasing power parity: the case of the Ringgit effective exchange rate

The paper investigates the extent to which the Ringgit exchange rate converges on its purchasing power parity level in the long run, using the cointegration and variance ratio tests. The results indicate that shifts in the real exchange rate are dominated by permanent stochastic shocks which prevent it from reverting to its PPP base level. Further analysis indicates that low frequency movements in the relative price of tradable goods and the external terms of trade cannot explain the long-run swing in the real exchange rate.     

A cointegration analysis of purchasing power parity: 1973–96

This paper tests the purchasing power parity (PPP) hypothesis for five industrial countries using cointegration and error-correction modeling. The cointegration test indicated that for all countries the PPP hypothesis holds in the long run but not in the short run. Further, the errorcorrection models suggested that deviations of the actual exchange rate from its long-run PPP value were corrected in subsequent periods. Finally, the high frequency monthly data models did a better job of tracking the turning points of the actual data than the low-frequency quarterly and yearly models.