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Purchasing Power Parity: Evidence from a New Test

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  • Klaassen, F.J.G.M.

    (Tilburg University, Center for Economic Research)

Abstract

Most economists intuitively consider purchasing power parity (PPP) to be true. Nevertheless, quite surprisingly, the empirical literature is not very supportive for PPP. In this paper, however, we find evidence in favor of PPP using a new test. The test is embedded in a Markov regime-switching model for the exchange rate, because earlier papers have shown that this model describes the data better than the popular random walk. We allow for PPP by making the regime-switching probabilities depend on the PPP deviation. Our second result is that PPP disequilibria have become shorter- lived for some exchange rates, which may be due to an increase in the trade openness of the countries involved.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 1999-09.

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Date of creation: 1999
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Handle: RePEc:dgr:kubcen:199909

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Related research

Keywords: purchasing power parity; Markov regime-switching; testing; forecasting; exchange rates;

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References

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  1. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
  2. Whitney K. Newey & Kenneth D. West, 1986. "A Simple, Positive Semi-Definite, Heteroskedasticity and AutocorrelationConsistent Covariance Matrix," NBER Technical Working Papers 0055, National Bureau of Economic Research, Inc.
  3. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
  4. Engel, Charles, 1994. "Can the Markov switching model forecast exchange rates?," Journal of International Economics, Elsevier, vol. 36(1-2), pages 151-165, February.
  5. Kenneth D. West & Dongchul Cho, 1994. "The Predictive Ability of Several Models of Exchange Rate Volatility," NBER Technical Working Papers 0152, National Bureau of Economic Research, Inc.
  6. Pagan, A.R. & Schwert, G.W., 1989. "Alternative Models For Conditional Stock Volatility," Papers 89-02, Rochester, Business - General.
  7. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  8. Durland, J Michael & McCurdy, Thomas H, 1994. "Duration-Dependent Transitions in a Markov Model of U.S. GNP Growth," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 279-88, July.
  9. Newey, Whitney K & West, Kenneth D, 1994. "Automatic Lag Selection in Covariance Matrix Estimation," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 631-53, October.
  10. Francis X. Diebold & James M. Nason, 1989. "Nonparametric exchange rate prediction?," Finance and Economics Discussion Series 81, Board of Governors of the Federal Reserve System (U.S.).
  11. Ghysels, Eric, 1994. "On the Periodic Structure of the Business Cycle," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 289-98, July.
  12. Kenneth A. Froot & Kenneth Rogoff, 1994. "Perspectives on PPP and Long-Run Real Exchange Rates," NBER Working Papers 4952, National Bureau of Economic Research, Inc.
  13. Jeffrey A. Frankel & Andrew K. Rose, 1995. "A Panel Project on Purchasing Power Parity: Mean Reversion Within and Between Countries," NBER Working Papers 5006, National Bureau of Economic Research, Inc.
  14. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
  15. Klaassen, F.J.G.M., 1999. "Long Swings in Exchange Rates: Are They Really in the Data?," Discussion Paper 1999-08, Tilburg University, Center for Economic Research.
  16. 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.
  17. Mark, Nelson C., 1990. "Real and nominal exchange rates in the long run: An empirical investigation," Journal of International Economics, Elsevier, vol. 28(1-2), pages 115-136, February.
  18. 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.
  19. Filardo, Andrew J, 1994. "Business-Cycle Phases and Their Transitional Dynamics," Journal of Business & Economic Statistics, American Statistical Association, vol. 12(3), pages 299-308, July.
  20. Gray, Stephen F., 1996. "Modeling the conditional distribution of interest rates as a regime-switching process," Journal of Financial Economics, Elsevier, vol. 42(1), pages 27-62, September.
  21. Kodde, David A & Palm, Franz C, 1986. "Wald Criteria for Jointly Testing Equality and Inequality Restriction s," Econometrica, Econometric Society, vol. 54(5), pages 1243-48, September.
  22. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May.
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Cited by:
  1. Morey, Matthew R. & Simpson, Marc W., 2001. "To hedge or not to hedge: the performance of simple strategies for hedging foreign exchange risk," Journal of Multinational Financial Management, Elsevier, vol. 11(2), pages 213-223, April.
  2. Simpson, Marc W., 2004. "Selectively hedging the US dollar with foreign exchange futures contracts," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 14(1), pages 75-86, February.
  3. Klaassen, F.J.G.M., 1999. "Have Exchange Rates Become More Closely Tied? Evidence from a New Multivariate GARCH Model," Discussion Paper 1999-10, Tilburg University, Center for Economic Research.
  4. Rodolfo Helg & Massimiliano Serati, 2000. "The speed of adjustment to PPP: is there any puzzle?," LIUC Papers in Economics 74, Cattaneo University (LIUC).
  5. Franc Klaassen, 2005. "Long Swings in Exchange Rates: Are They Really in the Data?," Journal of Business & Economic Statistics, American Statistical Association, vol. 23, pages 87-95, January.
  6. Franc Klaassen, 2000. "Why is it so Difficult to Find an Effect of Exchange Rate Risk on Trade?," Econometric Society World Congress 2000 Contributed Papers 0133, Econometric Society.

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