Testing Purchasing Power Parity Research Articles

Testing Purchasing Power Parity: results from a new foreign exchange market

This study examines whether the Purchasing Power Parity hypothesis holds in the foreign exchange market of Armenia, following the initiation of an independent foreign exchange market, after the country seceded from the Soviet Union and the rouble zone in 1993. OLS and highly efficient unit root tests provide results suggesting that PPP fails to hold both in the short-run and in the long-run, respectively. In addition, variance decompositions justify - in terms of the Balassa-Samuelson effect - why in the long-run the PPP is rejected by identifying real shocks as the main determinant of the Dram real exchange rate.

Extracting Inflation from Stock Returns to Test Purchasing Power Parity

Relative purchasing power parity (PPP) holds for pure price inflations, which affect prices of all goods and services by the same proportion, while leaving relative prices unchanged. Pure price inflations also affect nominal returns of all traded financial assets by exactly the same amount. Recognizing that relative PPP may not hold for the official inflation data constructed from commodity price indices because of relative price changes and other frictions that cause prices to be “sticky,” we provide a novel method for extracting a proxy for realized pure price inflation from stock returns. We find strong support for relative PPP in the short run using the extracted inflation measures.

Purchasing power parity, price indices, and exchange rate forcasts

This paper addresses the issue of using aggregate price indices for purchasing power parity (PPP) tests and the fitness of PPP as a model for exchange rate forecasting. Compared with consumer price index (CPI) and wholesale price index (WPI), the price index of traded-goods (TPI) appears to be a more appropriate price index for both PPP tests and exchange rate forecasting. It performs better in the tests and provides superior exchange rate forecasts, both within- and out-of-sample. While the half-life of the estimated deviations from PPP is about two years for the CPI and WPI-based real exchange rates, it is only one year for the TPI-based real exchange rates.

Testing Purchasing Power Parity in the Framework of Vector Error Correction Modelling - Financial and Economic Forecasting (Chapter 14)

In this chapter, the necessary condition and the necessary and sufficient condition for purchasing power parity (PPP) are sequentially tested for fourteen bilateral exchange rates. This test is undertaken in the framework of subset vector error correction modelling (VECM) with zero coefficients. This approach is different from the unit root based methods and the results are promising. Of the fourteen exchange rates tested, we find support for the necessary condition for PPP in half of them. The necessary and sufficient condition for PPP is then tested using both a bootstrap procedure and an F test. This condition is consistently accepted for three of the seven exchange rates investigated.

Testing the purchasing power parity in pooled systems of error correction models

Using panel time series data from 18 main industrial economies we test the purchasing power parity (PPP) for the post-Bretton Woods era. As base currencies, we use alternatively the Deutsche mark (DEM), the Japanese yen (JPY), and the US dollar (USD). We employ error correction models for single countries and on the level of pooled equations. Critical values for the applied likelihood ratio tests are estimated by means of the wild bootstrap which copes with heteroskedastic error distributions and contemporaneous cross equation error correlation. To assess the robustness of our results tests of PPP are performed recursively. We find that the PPP provides an accurate description of exchange rate dynamics if the DEM or the JPY are used as base currencies. Specified towards the USD, we reject the economic model. It turns out that this overall conclusion is not invariant with respect to the investigated sample period.

Purchasing Power Parity Tests in Cointegrated Panels

This paper employs recently developed techniques for testing hypotheses in cointegrated panels to test the strong version of purchasing power parity for a panel of post Bretton Woods data. We compare results using fully modified and dynamic OLS approaches, and strongly reject the hypothesis. We also introduce a new between-dimension dynamic OLS estimator and find that the between-dimension FMOLS and DOLS estimates of the long-run deviation from purchasing power parity are larger than the corresponding within-dimension estimates. Finally, we attempt to reconcile these rejections with the mixed findings that have been reported in panel unit root studies.

Long-Run Purchasing Power Parity with Asymmetric Adjustment

1. Introduction Despite its intuitive appeal, there is inconclusive evidence supporting purchasing power parity (PPP) between countries with low inflation rates during the post-Bretton Woods period. For example, Enders (1988), Taylor (1988), and MacDonald (1993) use various forms of cointegration tests-called stage-three tests-and find that real exchange rates exhibit large fluctuations with slow rates of decay toward a long-run mean. Froot and Rogoff's (1995) literature review presents a consensus estimate that deviations from long-run PPP have a half-life of about three years. This is somewhat disappointing since stage-three tests seem to be well suited to the task-they require no assumptions concerning exogeneity and they imply a sensible dynamic relationship among price levels and the exchange rate. The vast literature on PPP is indicative of the importance of the issue and the ambiguity of the findings. It is well recognized that standard cointegration tests have low power to reject the null hypothesis of no cointegration. This observation is especially relevant for PPP since any mean reversion in real rates is very gradual and the length of the post-Bretton Woods period sample period is relatively short. Efforts to increase the power of unit-root and stage-three tests have had mixed success. For example, Lothian and Taylor (1996) and Mark (1990) have tried to circumvent the low power of stage-three tests by using long spans of time-series data. Unfortunately, the use of long time spans raises the possibility of structural changes occurring during the period being examined. Panel unit-root tests are generally more supportive of PPP than are bilateral tests of real exchange rate behavior. For example, Oh (1996), Wei and Parsley (1995), and Wu (1996) have used panel data in order to enhance the power of standard unit-root tests. Although these particular articles are supportive of PPP, panel studies must deal with the thorny issues of cross-sectional correlation and the choice of the nations to include in the panel. Papell (1997) finds that allowing for serial correlation substantially weakens the evidence in favor of long-run PPP. O'Connell (1998) applies generalized least squares to panel data to eliminate any contemporaneous correlation in the error structure and finds no evidence supporting PPP The second problem with the standard unit-root and cointegration tests is that they implicitly assume symmetric adjustment. However, official intervention in the foreign exchange market means that nominal exchange rate adjustment may be asymmetric. Under a managed float, for example, one of the monetary authorities might be more willing to tolerate currency appreciation than depreciation. Similarly, a currency band mitigates exchange rate movements until the level of the band is altered. Furthermore, the slow adjustment of real exchange rates is often explained by the stickiness of national price levels. For example, in the well-known Dornbusch (1976) overshooting model, prices and the exchange rate move in the same proportion as the money supply in the very long run. However, in the short run, prices are sticky and monetary shocks cause PPP deviations since the exchange rate moves proportionately more than prices. Rhee and Rich (1995) and Madsen and Yang (1998) provide empirical evidence corroborating the implications of the asymmetric price adjustment models. The key point to note is that, if prices are primarily sticky in the downward direction, there is no reason to presuppose that real exchange rate adjustment is symmetric. In spite of the evidence supportive of asymmetric exchange rate and price adjustments, there are only a few nonlinear tests of PPP Although they do not explicitly test for PPP, Michael, Nobay, and Peel (1997) and Taylor and Sarno (1998) estimate real exchange rates as smooth-- transition threshold adjustment processes. Enders and Falk (1998) formally apply various nonlinear unit-root tests to real exchange rates and find little evidence of PPP. …

Testing for PPP and UIP in an FIML framework: Some evidence for Germany and Japan

This paper argues that international parity conditions should be tested using an econometric approach, which allows for possible interactions in the determination of prices, interest rates, and exchange rates, and also for different short- and long-run dynamics. Failure to do so might account for the apparent lack of empirical success of exchange rate models based on the purchasing power parity (PPP) and uncovered interest rate parity (UIP) hypotheses. By focusing on the German mark and the Japanese yen (both nominal effective rates and bilateral rates vis-à-vis the U.S. dollar), we show that empirical support for PPP and UIP can be found within a full-information maximum-likelihood (FIML) framework. This confirms that such structural hypotheses are to be tested in a multivariate cointegration system in order to draw valid inference.

Testing for PPP: Should We Use Panel Methods?

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.

Generalized purchasing power parity and the case of the European Union as a successful currency area

This article uses multicountry purchasing power parity (PPP) tests to study the success of the European monetary system (EMS) in creating a successful currency area for a stable European monetary union. If the EMS has sufficiently integrated the fundamentals within the European Union, then real exchange rates between member countries will share a common stationary trend when denominated by a common outside currency. Previous research using two-country PPP tests have been inadequate in explaining the nonstationary nature of real exchange rates between the EMS countries and nonmember countries. The use of generalized PPP tests can show that even though individual exchange rates within the EMS may appear to be nonstationary with respect to outside countries, some of them will combine to form a currency union with a stable stationary trend.

Pitfalls in panel tests of purchasing power parity

Pitfalls in Panel Tests of Purchasing Power Parity. —The results of panel unit root tests applied to real exchange rates as a test of long-run purchasing power parity (PPP) diverge much. In particular, due to misspecifications there is little evidence of the convergence of real exchange rates for the German mark. This paper provides evidence of this issue by analyzing large panels of real exchange rates vis-a-vis the German mark and the dollar. In particular, the impact of the base country and various aspects of the dynamic specifications are analyzed. Overall, the results provide strong evidence in favour of PPP as a long-run relationship.

Testing for Purchasing Power Parity: Econometric Issues and an Application to Developing Countries

There is now a vast literature on testing purchasing power parity (PPP). Any test is conditional on a particular econometric specification which embodies a set of auxiliary assumptions. This paper reviews the issues involved in econometric specification and estimation in the time series and panel models used to test PPP. We start from a general model and then systematically examine the implicit restrictions that are imposed to obtain the standard procedures and discuss the implications of these procedures for estimation and inference. The issues are illustrated on data for a panel of 31 developing countries, 1966–90.

Testing Purchasing Power Parity Theory: A Case Study in Non-Falsificationism

This paper examines empirical tests of purchasing power parity theory (PPP) from a methodological perspective. In particular the issue of whether economists have seriously attempted to falsify the theory is addressed. While the results of econometric tests have been largely negative, this has not led to the falsification of PPP or its rejection by economists. The main reason for this is that economists have in practice adopted a methodology resembling the older inexact method a priori, revived recently by Hausman. The intensive econometric work into PPP may thus be construed as the attempt to find satisfactory empirical models of the theory or testing for the limitations and range of application of the underlying theory, rather than seriously testing the theory with a view to falsification. The nature and extent of the progress made in this field is also questioned.

Measuring Misalignment: PPP and East Asian Currencies in the 1990's

The concept of purchasing power parity (PPP) is used as an equilibrium exchange rate measure to evaluate whether eight East Asian currencies were overvalued on the eve of the 1997 currency crises: Hong Kong dollar, Indonesian rupiah, Korean won, Malaysian ringgit, Philippine peso. Singapore dollar, Taiwanese dollar and the Thai baht. Using both the Johansen and Horvath-Watson cointegration test procedures, the purchasing power parity tests are performed on bilateral (US$, yen) and multilateral exchange rates, using consumer price indices, producer price indices, and price indices of export goods. The second deflator yields the greatest evidence of stationarity. I find that the Hong Kong dollar, ringgit, Philippine peso, and baht were overvalued as of May 1997, according to the PPP criterion, while the won and the New Taiwan dollar were substantially undervalued. The implied deviations are compared against those obtained using simple trends in consumer price index deflated real rates; these trend based calculations typically suggest larger overvaluations than their producer price deflated counterparts.

Testing purchasing power parity in the presence of transaction costs

This paper examines long-run purchasing power parity (PPP) using a new formulation of PPP in the presence of transaction costs. Our results strongly support the proposition that PPP holds as a long-run equilibrium condition.

Intra-National, Intra-Continental, and Intra-Planetary PPP

This paper presents a general framework to address several issues that have arisen in recent work that investigates purchasing power parity (PPP) and other inter-regional relative price movements: (1) How can we model real exchange rate movements in a consistent manner, so that our model for the real exchange rate for country B relative to country C is commensurate with our models for country A/ country B and country A/ country C real exchange rates? For example, can things be modeled so that our tests do not depend on the "base country"? (2) How should we handle correlation across real exchange rates in panel tests of PPP? (3) Are speeds of adjustment toward PPP different for intra-national, cross-national and cross-continental real exchange rates? (4) Is the innovation variance different for intra-national, cross-national and cross-continental real exchange rates; and, if so, how does that influence how we model and test PPP?

Policy convergence, the exchange rate mechanism and the misalignment of exchange rates. Some tests of purchasing power parity and generalized purchasing power parity

The paper focuses on the convergence issues and the long-run credibility of the European Monetary System (EMS), and, more specifically, on the evaluation of the effectiveness of the Exchange Rate Mechanism (ERM) in generating a stabilizing effect on real exchange rates across member countries. For this purpose, we execute some tests of long-run purchasing power parity (PPP) for an ERM group and a non-ERM group of countries using both the Engle and Granger procedure and the more powerful Johansen cointegration technique. We also execute a test of Generalized PPP, exploiting an idea developed by Enders and Hurn. Testing for PPP in a multicountry setting may be a useful methodology to identify the optimal currency area suggested by the data generation process, on the basis of the reported homogeneity of real exchange rate behaviour of the countries considered.

Testing for absolute purchasing power parity

Purchasing power parity (PPP) is an equilibrium condition equating the nominal exchange rate between two countries with the relative price of an identical bundle of goods in each country. Previous time-series researchers use price indices to study PPP, so they test relative PPP. We use new data that measures price levels, so we test absolute PPP. Price levels provide a test of absolute PPP because, unlike price indices, price levels do not contain a base period in which the nominal exchange rate equals the price ratio by construction. We find support for absolute PPP.

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.

Testing purchasing power parity in a multivariate cointegrating framework

This paper examines a bilateral PPP(Purchasing power parity) relationship between Australia and the 11 major trading countries by means of two alternative econometric techniques-a multivariate cointegrating framework and a band-spectral regression. It is acknowledged that there is no strong evidence that classical PPP holds in all cases. However, the generalized version of PPP holds in all cases, and provides a better explanation of the long-run relations between exchange rates and relative prices.The use of different price indices, i.e CPI and WPI,lead to different estimates and hence different policy implications.