If Purchasing Power Parity holds in the long run, then real exchange rates are mean stationary. To test this hypothesis, monthly data on bilateral real exchange rates between the United States and five countries extending back to the 1920s are calculated. The null hypothesis of mean stationarity is tested against a variety of nonstationary alternatives. Our results strongly favor mean stationarity over models that permit long-run trends in real exchange rates. The data also favor stationarity over a unit root process with no drift. We show that the realized path of the real exchange rate lies predominantly within the prediction interval for a stationary AR(1) model, a result that is more consistent with stationarity than with a unit root. We develop simple statistics that make this intuitive reasoning more precise. Finally, the data contain no reliable evidence of discrete shifts in the mean of the real exchange rate. Thus, PPP appears to provide a reasonable characterization of the long-run behavior of national price levels and exchange rates.
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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number
95-14.
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