Testing for PPP: Should We Use Panel Methods?

Abstract

A common finding in the empirical literature on the validity of purchasing power parity (PPP) is that it holds when tested for in panel data, but not in univariate (i.e. country specific) analysis. The usual explanation for this mismatch is that panel tests for unit roots and cointegration are more powerful than their univariate counterparts. In this paper we suggest an alternative explanation for the mismatch. More generally, we warn against the use of panel methods for testing for unit roots in macroeconomic time series. Existing panel methods assume that cross-unit cointegrating or long-run relationships, that tie the units of the panel together, are not present. However, using empirical examples on PPP for a panel of OECD countries, we show that this assumption is very likely to be violated. Simulations of the properties of panel unit root tests in the presence of long-run cross-unit relationships are then presented to demonstrate the serious cost of assuming away such relationships. The empirical size of the tests is substantially higher than the nominal level, so that the null hypothesis of a unit root is rejected very often, even if correct.