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Purchasing Power Parity for Traded and Non-traded Goods: A Structural Error Correction Model Approach

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  • Masao Ogaki
  • Jaebeom Kim

Abstract

When univariate methods are applied to real exchange rates, point estimates of autoregressive coefficients typically imply very slow rates of mean reversion. Rogoff (1996) discusses that the remarkable consensus of 3-5 year half-lives of purchasing power parity (PPP) deviations is found among studies using long-horizon data. However, a recent study by Murray and Papell (2002) calculates confidence intervals for estimates of half-lives for long-horizon and post-1973 data, and concludes that univariate methods provide virtually no information regarding the size of the half-lives. This paper estimates half-lives of real exchange rates for traded and non-traded goods with a system method based on Kim, Ogaki, and Yang’s (2001) structural Error Correction Model (ECM). This system method employs a modified version of Mussa’s (1982) model with traded and non-traded goods in which the exchange rate exhibits overshooting as in Dornbush’s (1976) model. The model includes a gradual adjustment equation, in which the domestic price of the traded good adjusts to the long-run equilibrium level determined by PPP. Kim, Ogaki, and Yang’s (2001) system method combines the single equation IV method with Hansen and Sargent’s (1982) method, which applies Hansen’s (1982) Generalized Method of Moments (GMM) to linear rational expectations models. In this paper, we estimate half-lives of real exchange rates based on traded good price indices, those based on non-traded good price indices, and those based on general price indices. The half-lives of the real exchange rates based on traded good price indices are expected to be shorter than those based on non-traded good or general price indices. We use the producer price indices (PPI), the consumer price indices (CPI), and GDP deflators from 1973 Q1 to 2001 Q1 to construct the real exchange rates for traded, non-traded, and general prices, respectively. The seven countries included in our study are Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. When the system method is applied, our point estimates indicate shorter half-lives for traded good price indices than for non-traded and general good price indices.

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 Far Eastern Meetings with number 515.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:feam04:515

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Keywords: Purchasing Power Parity; Structural Error Correction Model; Real Exchange Rate; Half-life; Convergence Rate;

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References

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  2. David Papell, 1998. "The Great Appreciation, the Great Depreciation, and the Purchasing Power Parity Hypothesis," Working Papers 30, Oesterreichische Nationalbank (Austrian Central Bank).
  3. Hyoung-Seok Lim & Masao Ogaki, 2003. "A Theory of Exchange Rates and the Term Structure of Interest Rates," RCER Working Papers 504, University of Rochester - Center for Economic Research (RCER).
  4. Jaebeom Kim & Masao Ogaki & Minseok Yang, 2003. "Structural Error Correction Models: Instrumental Variables Methods and an application to an exchange rate model," RCER Working Papers 502, University of Rochester - Center for Economic Research (RCER).
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Citations

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Cited by:
  1. Hyeongwoo Kim & Masao Ogaki, 2011. "Purchasing Power Parity and the Taylor Rule," Auburn Economics Working Paper Series auwp2011-02, Department of Economics, Auburn University.
  2. Nikolaos Giannellis & Athanasios Papadopoulos, 2007. "Nonlinear Exchange Rate Adjustment in the Enlarged Euro zone. Evidence and Implications for Candidate Countries," Working Papers 0718, University of Crete, Department of Economics.
  3. Mario J. Crucini & Mototsugu Shintani, 2006. "Persistence in Law-of-One-Price Deviations: Evidence from Micro-data," Levine's Bibliography 321307000000000311, UCLA Department of Economics.
  4. Masao Ogaki & Sungwook Park, 2007. "Long-run real exchange rate changes and the properties of the variance of k-differences," Working Papers 07-05, Ohio State University, Department of Economics.
  5. Jaebeom Kim & Masao Ogaki & Minseok Yang, 2003. "Structural Error Correction Models: Instrumental Variables Methods and an application to an exchange rate model," RCER Working Papers 502, University of Rochester - Center for Economic Research (RCER).
  6. Hwa-Taek Lee & Gawon Yoon, 2013. "Does purchasing power parity hold sometimes? Regime switching in real exchange rates," Applied Economics, Taylor & Francis Journals, vol. 45(16), pages 2279-2294, June.

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