Testing for Purchasing Power Parity in Cointegrated Panels

Johan Lyhagen · Pär Österholm · Mikael Carlsson

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Abstract

This paper applies the maximum likelihood panel cointegration method of Larsson and Lyhagen (2007) to test the strong PPP hypothesis using data for the G7 countries. This method is robust in several important dimensions relative to previous methods, including the well-known issue of cross-sectional dependence of error terms. The findings using this new method are contrasted to those from the Pedroni (1995) cointegration tests and fully modified OLS and dynamic OLS esimators of the cointegrating vectors. Our overall results are the same across all approaches: The strong PPP hypothesis is rejected in favour of weak PPP with heterogenenous cointegrating vectors.

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References

1987Co-Integration and Error Correction: Representation, Estimation, and Testing 1988Statistical analysis of cointegration vectors 2003Testing for unit roots in heterogeneous panels 2002Unit root tests in panel data: asymptotic and finite-sample properties 1992Testing the null hypothesis of stationarity against the alternative of a unit root 1999A Comparative Study of Unit Root Tests with Panel Data and a New Simple Test 2004PANEL COINTEGRATION: ASYMPTOTIC AND FINITE SAMPLE PROPERTIES OF POOLED TIME SERIES TESTS WITH AN APPLICATION TO THE PPP HYPOTHESIS 1999Spurious regression and residual-based tests for cointegration in panel data

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