On the Empirical Failure of Purchasing Power Parity Tests

Matteo Maria Pelagatti · Emilio Colombo

10 citations0/0 files storedJournal of Applied Econometrics

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Abstract

Summary Empirical research on the validity of the purchasing power parity (PPP) condition is generally based on real exchange rates built using the consumer price index (CPI), but fails to provide clear support to PPP. In this paper we show theoretically that, even if the law of one price (LOP) holds for traded goods, CPI‐based real exchange rates are not mean reverting, and are neither stationary nor integrated. Therefore, both unit root and stationarity tests should reject their null. Our theoretical results are validated both by simulations and an empirical application. Copyright © 2014 John Wiley & Sons, Ltd.

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References

1979Distribution of the Estimators for Autoregressive Time Series with a Unit Root 1992Testing the null hypothesis of stationarity against the alternative of a unit root 1979Distribution of the Estimators for Autoregressive Time Series With a Unit Root 1996Efficient Tests for an Autoregressive Unit Root 1992Efficient Tests for an Autoregressive Unit Root 1991Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimation 1996The Purchasing Power Parity Puzzle 2002Dynamic Panel Estimation and Homogenity Testing Under Cross Section Dependence

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