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.     

Are Real Interest Rates Equal Across Countries? An Empirical Investigation of International Parity Conditions

This paper conducts empirical tests of the equality of real interest rates across countries. The empirical evidence strongly rejects the hypothesis of real rate equality and the joint hypotheses of uncovered interest parity and ex ante relative PPP, or the unbiasedness of forward rate forecasts and ex ante relative PPP. The evidence suggests that it is worth studying open economy macroeconomic models which allow: 1) domestic real rates to differ from world rates, 2) time varying risk premiums in the forward market, or 3) deviations from ex ante relative PPP.     

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.     

International tax arbitrage via corporate income splitting

Abstract

If capital for corporate finance was available from a common global pool and at zero transaction cost, then does after-tax arbitrage require harmonization of income tax rates across jurisdictions? This paper shows that the answer is in the negative. When a corporation has the choice of deciding the fraction of income that it distributes as dividends with the remainder held for future capitalization, then such choice brings about arbitrage in after-tax rates of return to investors facing a common pre-tax return but different rates of income taxes. Policy implications are drawn from this result.     

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 fundamental theory of exchange rates and direct currency trades

In this paper we construct a two-country search model to determine the nominal exchange rate between two fiat monies. Our model allows agents to use any currency to trade for goods in all countries. However, search frictions restrict agents’ opportunities for instantaneous arbitrage, and hence make the nominal exchange rate determinate. The nominal exchange rate depends on the two countries’ economic fundamentals, including the stocks and growth rates of the two monies. Direct exchanges between currencies are essential and they imply a nominal exchange rate that is different from the relative price between the two currencies in the goods markets. There are persistent violations of the law of one price and purchasing power parity in equilibrium, despite the fact that prices are perfectly flexible and all goods are tradeable between countries. Nominal and real exchange rates can move together in the steady state in response to money growth shocks.     

International tax arbitrage,financial parity conditions and preferential capital gains taxation

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation when interest income and capital gains/losses are taxed differentially for some agents. We derive tax-modified uncovered interest parity conditions, Fisher conditions and forward prices similar to the no-tax ones, but augmented by tax-induced ‘risk-premium’ terms; covered interest parity and Fisher conditions remain unaffected by the introduction of capital income taxes as we bound tax-based arbitrage without restricting arbitrage per se.     

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.     

The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity

With transaction costs for trading goods, the nominal exchange rate moves within a band around the nominal purchasing power parity (PPP) value. We model the behavior of the band and of the exchange rate within the band. The model explains why there are below-unity slope coefficients in regression tests of PPP, and why these increase toward unity under hyperinflation or with low-frequency data. Our results are independent of the presence of nontraded goods in the economy.     

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.     

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.     

Devaluation, Fiscal Deficits, and the Real Exchange Rate

This article examines the use of fiscal policies to sustainthe effects of a nominal devaluation on the real exchange rate.It is shown that the magnitude of the change in the real exchangerate depends not only on the size of the devaluation and thedegree of fiscal adjustment but also on the means by which thefiscal deficit is reduced. The change in the nominal exchangerate necessary to maintain the depreciation of the real exchangerate will depend on whether the fiscal deficit is eliminatedby increasing taxes or by reducing government expenditures ontraded and nontraded goods. The required depreciation of thedomestic currency will be larger if the fiscal deficit is reducedby increasing taxes than it will be if the deficit is cut bylowering government expenditures. Further, the depreciationwould be smaller if the cuts in expenditure fell on traded ratherthan nontraded goods. This result implies that the authoritiesmust ensure consistency between exchange rate action and policiesto reduce fiscal imbalances in order to achieve a desired levelof the real exchange rate necessary to attain balance of paymentsequilibrium.     

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.     

Triangular arbitrage in the spot and forward foreign exchange markets

Imad Moosa shows that the effect of triangular arbitrage in the forward market is similar to the combined effect of triangular arbitrage in the spot market and covered interest arbitrage. He also shows that when the forward rates are inconsistent then this implies inconsistency of the spot rates and/or the violation of covered interest parity. When the bid-offer spreads are allowed for, the equilibrium conditions hold only approximately.     

Examining the Equilibrium Relationship Between the Shanghai 50 Stock Index Futures and the Shanghai 50 ETF Options Markets

Based on the put-call-futures parity model, this article studies the equilibrium relationship between the Shanghai 50 stock index futures and the Shanghai 50 Exchange-Traded Fund (ETF) options markets by analyzing the arbitrage opportunities and profits between these two derivative markets. This article reveals that the cost spread, option volatility, days from the expiration date, moneyness of options, trading strategy, and policy factors all have a great impact on the arbitrage profits and opportunities. In addition, significant arbitrage profits and opportunities indicate violations of put-call-futures parity. Although no equilibrium relationship exists between the Shanghai 50 stock index futures and the Shanghai 50 ETF options markets, efficiency in these markets has gradually improved.     

Liquidity and Arbitrage in Options Markets: A Survival Analysis Approach

This paper examines the determinants of the time it takes foran index options market to return to no arbitrage values afterput-call parity deviations, using intraday transactions datafrom the French index options market. We employ survival analysisto characterize how limits to arbitrage influence the expectedduration of arbitrage deviations. After controlling for conventionallimits to arbitrage, we show that liquidity-linked variablesare associated with a faster reversion of arbitrage profits.The introduction of an Exchange Traded Fund also affects thesurvival rates of deviations, but this impact essentially stemsfrom the reduction in the level of potential arbitrage profits.     

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.     

Real exchange rates and nontradables: A relative price approach

In this paper, we study long-run comovements of real exchange rates and relative prices of nontradables and tradables. This approach is complementary to many existing approaches to investigating real exchange rate movements. In many theoretical models of exchange rate determination, the relative prices of nontradables and tradables are linked to the real exchange rates by identities. However, they do not necessarily move with real exchange rates in reality because of many factors. For example, many tradables contain nontradable components in the form of retailing services, so that Purchasing Power Parity (PPP) may not hold for these tradable goods even in the long run. Hence real exchange rates may not move in the direction predicted by theoretical models when the producers of these tradable goods experience changes in productivity. In this paper, we identify time periods, countries and relative price measures for which comovements between real exchange rates and relative prices of nontradables and tradables are observed.     

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.     

Risk taking and taxation in complete capital markets

In general equilibrium, with complete conventional securities markets and endogenous asset supply, taxes on risk remuneration are ineffective but harmless. They do not alter the real allocation of goods or the distribution of wealth, they impose no excess burden, and, in particular, have no impact on risk taking.