Real Exchange Rates, PPP and the Relative Price of Nontraded Goods

Abstract

The purchasing power parity hypothesis (PPP) states that nominal exchange rates move with differences in relative prices between economies. The theory has received considerable attention in the economic literature since Cassell [6], and is the foundation of many long-run theoretical hypotheses in international finance; yet, its empirical validity remains in question. Many tests of PPP focus on the stationarity of the real exchange rate, the nominal exchange rate adjusted for changes in price levels between economies. If domestic and foreign price levels and the nominal exchange rate are integrated, then cointegration between these variables implies the existence of both a long-run equilibrium relationship and PPP. The residual, the real exchange rate, then follows a stationary process. The paper uses the multivariate cointegration methodology of Johansen [16] and Johansen and Juselius [17; 18] to examine the source of real exchange rate nonstationarity. Is the nonstationarity due to shifts in the domestic and foreign price of nontradeables or productivity differentials between traded and nontraded sectors? Or is the nonstationarity a possible outcome of difficulties in intercountry comparisons of prices movements associated with construction of these price indices? Most research finds the real exchange rate follows a nonstationary process due to the presence of a unit root [8; 12; 1; 9; 19; 27]. However, the existence of a variable trend in the real exchange rate does not imply the absence of a long-run relationship between relative prices levels and nominal exchange rates for two reasons. First, a long-run relationship between price levels and nominal exchange rates may exist but not the one-for-one relationship implicit in the calculation of real exchange rates due to measurement differences in the construction of price indices between economies. Second, PPP violations may occur due to the presence of permanent productivity innovations which affect the relative price of nontradeables. If these shocks are not represented by measurable variables, a cointegrating relationship will not exist. The paper constructs traded and nontraded GDP price indices and productivity rates for 14 OECD economies, and tests: (1) if the variable trend (the nonstationary process) in the real exchange rate is due to permanent innovations in relative price of domestic and foreign nontradeables; (2) if long-run PPP violations are due to permanent movements in the relative price of nontradeables; (3) if the nonstationarity in the real exchange rate is due to permanent innovations in domestic and foreign productivity differentials between the traded and nontraded sectors; (4) if the variable trend in the relative price of nontradeables is due to permanent innovations in productivity between sectors. Lastly, the paper constructs a cointegrating error correction model