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Purchasing Power Parity and Heterogenous Mean Reversion

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  • Koedijk, Kees
  • Tims, Ben
  • Van Dijk, Mathijs A

Abstract

This paper analyses the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. This can have a dramatic impact on inferences made on the validity of the PPP hypothesis. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5473.

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Date of creation: Jan 2006
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Handle: RePEc:cpr:ceprdp:5473

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Keywords: heterogeneity; international economics; panel models; Purchasing power parity; real exchange rates; unit root tests;

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References

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  1. Jorion, Philippe & Sweeney, Richard J., 1996. "Mean reversion in real exchange rates: evidence and implications for forecasting," Journal of International Money and Finance, Elsevier, vol. 15(4), pages 535-550, August.
  2. Papell, David H., 2002. "The great appreciation, the great depreciation, and the purchasing power parity hypothesis," Journal of International Economics, Elsevier, vol. 57(1), pages 51-82, June.
  3. Claude Lopez & David H. Papell, 2007. "Convergence to Purchasing Power Parity at the Commencement of the Euro," Review of International Economics, Wiley Blackwell, vol. 15(1), pages 1-16, 02.
  4. Jean Imbs & Haroon Mumtaz & Morton O. Ravn & Helene Rey, 2002. "PPP Strikes Back: Aggregation and the Real Exchange Rate," NBER Working Papers 9372, National Bureau of Economic Research, Inc.
  5. Pesaran, M.H. & Smith, R., 1992. "Estimating Long-Run Relationships From Dynamic Heterogeneous Panels," Cambridge Working Papers in Economics 9215, Faculty of Economics, University of Cambridge.
  6. Koedijk, Kees & Tims, Ben & Van Dijk, Mathijs A, 2004. "Purchasing Power Parity and the Euro Area," CEPR Discussion Papers 4510, C.E.P.R. Discussion Papers.
  7. John Y. Campbell & Pierre Perron, 1991. "Pitfalls and Opportunities: What Macroeconomists Should Know About Unit Roots," NBER Chapters, in: NBER Macroeconomics Annual 1991, Volume 6, pages 141-220 National Bureau of Economic Research, Inc.
  8. Taylor, Mark P. & Sarno, Lucio, 1998. "The behavior of real exchange rates during the post-Bretton Woods period," Journal of International Economics, Elsevier, vol. 46(2), pages 281-312, December.
  9. Papell, David H., 1997. "Searching for stationarity: Purchasing power parity under the current float," Journal of International Economics, Elsevier, vol. 43(3-4), pages 313-332, November.
  10. Abuaf, Niso & Jorion, Philippe, 1990. " Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 45(1), pages 157-74, March.
  11. Levin, Andrew & Lin, Chien-Fu & James Chu, Chia-Shang, 2002. "Unit root tests in panel data: asymptotic and finite-sample properties," Journal of Econometrics, Elsevier, vol. 108(1), pages 1-24, May.
  12. Robertson, D & Symons, J, 1992. "Some Strange Properties of Panel Data Estimators," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(2), pages 175-89, April-Jun.
  13. O'Connell, Paul G. J., 1998. "The overvaluation of purchasing power parity," Journal of International Economics, Elsevier, vol. 44(1), pages 1-19, February.
  14. Fleissig, Adrian R. & Strauss, Jack, 2000. "Panel unit root tests of purchasing power parity for price indices," Journal of International Money and Finance, Elsevier, vol. 19(4), pages 489-506, August.
  15. Wu, Jyh-Lin & Wu, Shaowen, 2001. "Is Purchasing Power Parity Overvalued?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 804-12, August.
  16. Koop, Gary, 1992. "'Objective' Bayesian Unit Root Tests," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(1), pages 65-82, Jan.-Marc.
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Cited by:
  1. Maican, Florin G. & Sweeney, Richard J., 2006. "Real Exchange Rate Adjustment In European Transition Countries," Working Papers in Economics 202, University of Gothenburg, Department of Economics.

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