Purchasing Power Parity under the Gold Standard

Abstract

1. Introduction Long-run purchasing power parity (LRPPP), mainstay of international economic theory, has proved difficult to back up empirically. Many attempts have been made using various time series of data, yet results continue to be mixed.' A standout exception to these mixed results is presented by Diebold, Husted, and Rush (1991), whose work has been interpreted as very strong evidence of LRPPP because of their across-the-board rejection of the unit root for large sample of real exchange rates. Baillie (1996, p. 51) cites Diebold, Husted, and Rush as reestablishing Purchasing Power Parity as meaningful long run concept despite the substantial mixed results of other studies. These mixed results are usually attributed to the power problems associated with standard unit root tests, especially for small samples. Diebold, Husted, and Rush (1991) overcome these shortcomings by loosening the structure of the model to allow longmemory process. Diebold, Husted, and Rush (1991) model real exchange rate behavior using autoregressive, fractionally integrated moving-average (ARFIMA) models. In doing so, they reject the unit root for 16 real exchange rates from the gold standard era in favor of fractionally integrated alternative hypothesis. A long-memory process is essentially stationary one, where the autocorrelations take far longer to decay than the exponential rate associated with the autoregressive moving average (ARMA) class (Baillie 1996, p. 6). This observation implies that purchasing power parity (PPP) holds, but in some cases only in the extreme long run. We agree with Diebold, Husted, and Rush (1991) that the structure of standard unit root tests is overly restrictive. However, we offer different solution to this problem. From standard unit root tests, one must conclude that either all deviations from PPP are permanent or all deviations dissipate over time. However, there is third possibility that has both theoretical and empirical support. Unit root tests do not allow the possibility that while most deviations dissipate, few remain as permanent shocks. Real exchange rates may show substantial mean reversion, but to changing mean rather than to the constant PPP value. This idea, which we call quasi purchasing power parity (QPPP), draws support from the BalassaSamuelson theory, which asserts that productivity shocks can have permanent effects on real exchange rates. Samuelson (1994, p. 202) criticizes economists who tried to use PPP as guide even when substantive microeconomic changes had taken place between the previous putative equilibrium period and the new status quo. He cites an example from the 1980s when the actual yen/dollar exchange rate was 150 yen per dollar. According to PPP, the equilibrium exchange rate was 200 yen per dollar, yet the rate proceeded to drop to 110 yen per dollar and below. In QPPP terms, this situation would represent not lack of mean reversion, but evidence of an equilibrium that had shifted away from PPP This is form of the Penn effect, whereby a rich country, in comparison with poor one, will be estimated to be richer than it really is if you pretend that the simplified Cassel version of purchasing-power parity ... is correct (Samuelson 1994, p. 201). We assert that this Penn effect can occur not just between rich and poor countries, but between any two countries if one of these countries is affected by permanent external shock. QPPP also supports Engel's (1996, p. 1) proposition that the real exchange rate evolves as the sum of two processes-a stationary but persistent component and non-stationary component. It is generally held that while the exchange rate deviates from its long-run equilibrium value in the short run, it eventually converges to that equilibrium value in the long run. The question, then, is, What is that long-run equilibrium value? Some argue it is the PPP level, while others argue that there is complex set of factors determining the long-run value, including such things as the relative labor productivities at home and abroad (Engel 1996, p. …