Long-Run PPP under the Presence of Near-to-Unit Roots: The Case of the British Pound-US Dollar Rate

Abstract

Empirical tests typically provide evidence that the British pound–US dollar exchange rate and the relative wholesale price index contain exact unit roots and exhibit cointegration. However, the cointegrating vector is significantly different from [1, −1], thus raising doubts on the validity of the purchasing power parity (PPP) hypothesis. Following Elliott (1998), we show that if the exchange rate and relative price series contain near-to-unit roots in the context of a bivariate system, then any inference on the “cointegrating” vector and consequently on PPP, which is based on standard cointegration estimation methods, will be misleading. We then argue that the existing evidence against the PPP hypothesis in the British pound–US dollar market can be attributed to the finite sample bias of the standard cointegration estimators, arising from an endogenous and “nearly” nonstationary regressor. We also show that when robust procedures are employed the evidence favors the PPP hypothesis.