Purchasing Power Parity and Heterogenous Mean Reversion
AbstractThis 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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Bibliographic InfoPaper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5473.
Date of creation: Jan 2006
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Other versions of this item:
- Koedijk, C.G. & Tims, B. & Dijk, M.A. van, 2005. "Purchasing Power Parity and Heterogeneous Mean Reversion," Research Paper ERS-2005-085-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.
- F31 - International Economics - - International Finance - - - Foreign Exchange
- F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-02-12 (All new papers)
- NEP-FIN-2006-02-12 (Finance)
- NEP-FMK-2006-02-12 (Financial Markets)
- NEP-IFN-2006-02-12 (International Finance)
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