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Testing for PPP: Should We Use Panel Methods?

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  • Anindya Banerjee
  • Massimiliano Marcellino
  • Chiara Osbat

Abstract

A common finding in the empirical literature on the validity of purchasing power parity (PPP) is that it holds when tested for in panel data, but not in univariate (i.e. country specific) analysis. The usual explanation for this mismatch is that panel tests for unit roots and cointegration are more powerful than their univariate counterparts. In this paper we suggest an alternative explanation for the mismatch. More generally, we warn against the use of panel methods for testing for unit roots in macroeconomic time series. Existing panel methods assume that cross-unit cointegrating or long-run relationships, that tie the units of the panel together, are not present. However, using empirical examples on PPP for a panel of OECD countries, we show that this assumption is very likely to be violated. Simulations of the properties of panel unit root tests in the presence of long-run cross-unit relationships are then presented to demonstrate the serious cost of assuming away such relationships. The empirical size of the tests is substantially higher than the nominal level, so that the null hypothesis of a unit root is rejected very often, even if correct.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 186.

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Handle: RePEc:igi:igierp:186

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  1. Papell, David H., 2002. "The great appreciation, the great depreciation, and the purchasing power parity hypothesis," Journal of International Economics, Elsevier, Elsevier, vol. 57(1), pages 51-82, June.
  2. Rolf Larsson & Johan Lyhagen, 2000. "Likelihood-Based Inference in Multivariate Panel Cointegration Models," Econometric Society World Congress 2000 Contributed Papers, Econometric Society 1313, Econometric Society.
  3. Johansen, Soren, 1995. "Likelihood-Based Inference in Cointegrated Vector Autoregressive Models," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198774501, October.
  4. Oh, Keun-Yeob, 1996. "Purchasing power parity and unit root tests using panel data," Journal of International Money and Finance, Elsevier, Elsevier, vol. 15(3), pages 405-418, June.
  5. Papell, David H & Theodoridis, Hristos, 2001. "The Choice of Numeraire Currency in Panel Tests of Purchasing Power Parity," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 33(3), pages 790-803, August.
  6. J.J.J. Groen & F. Kleibergen, 2001. "Likelihood-Based Cointegration Analysis in Panels of Vector Error Correction Models," WO Research Memoranda (discontinued), Netherlands Central Bank, Research Department 646, Netherlands Central Bank, Research Department.
  7. Charles Engel, 1996. "Long-Run PPP May Not Hold After All," NBER Working Papers 5646, National Bureau of Economic Research, Inc.
  8. Mark, Nelson C, 1995. "Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability," American Economic Review, American Economic Association, American Economic Association, vol. 85(1), pages 201-18, March.
  9. Banerjee, A. & Marcellino, M. & Osbat, C., 2000. "Some Cautions on the Use of Panel Methods for Integrated Series of Macro-economic Data," Economics Working Papers, European University Institute eco2000/20, European University Institute.
  10. Papell, David H., 1997. "Searching for stationarity: Purchasing power parity under the current float," Journal of International Economics, Elsevier, Elsevier, vol. 43(3-4), pages 313-332, November.
  11. Pasaran, M.H. & Im, K.S. & Shin, Y., 1995. "Testing for Unit Roots in Heterogeneous Panels," Cambridge Working Papers in Economics, Faculty of Economics, University of Cambridge 9526, Faculty of Economics, University of Cambridge.
  12. Peter Pedroni, 1999. "Critical Values for Cointegration Tests in Heterogeneous Panels with Multiple Regressors," Department of Economics Working Papers, Department of Economics, Williams College 2000-02, Department of Economics, Williams College.
  13. Pesaran, M.H. & Smith, R., 1992. "Estimating Long-Run Relationships From Dynamic Heterogeneous Panels," Cambridge Working Papers in Economics, Faculty of Economics, University of Cambridge 9215, Faculty of Economics, University of Cambridge.
  14. Gonzalo, Jesus & Granger, Clive W J, 1995. "Estimation of Common Long-Memory Components in Cointegrated Systems," Journal of Business & Economic Statistics, American Statistical Association, American Statistical Association, vol. 13(1), pages 27-35, January.
  15. Banerjee, Anindya, 1999. " Panel Data Unit Roots and Cointegration: An Overview," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, Department of Economics, University of Oxford, vol. 61(0), pages 607-29, Special I.
  16. Tamim Bayoumi & Ronald MacDonald, 1999. "Deviations of Exchange Rates from Purchasing Power Parity: A Story Featuring Two Monetary Unions," IMF Staff Papers, Palgrave Macmillan, vol. 46(1), pages 5.
  17. Perron, Pierre, 1989. "The Great Crash, the Oil Price Shock, and the Unit Root Hypothesis," Econometrica, Econometric Society, Econometric Society, vol. 57(6), pages 1361-1401, November.
  18. 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, Elsevier, vol. 108(1), pages 1-24, May.
  19. Badi H. Baltagi & Chihwa Kao, 2000. "Nonstationary Panels, Cointegration in Panels and Dynamic Panels: A Survey," Center for Policy Research Working Papers, Center for Policy Research, Maxwell School, Syracuse University 16, Center for Policy Research, Maxwell School, Syracuse University.
  20. O'Connell, Paul G. J., 1998. "The overvaluation of purchasing power parity," Journal of International Economics, Elsevier, Elsevier, vol. 44(1), pages 1-19, February.
  21. Frankel, Jeffrey A. & Rose, Andrew K., 1995. "Empirical research on nominal exchange rates," Handbook of International Economics, Elsevier, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 33, pages 1689-1729 Elsevier.
  22. Jorion, Philippe & Sweeney, Richard J., 1996. "Mean reversion in real exchange rates: evidence and implications for forecasting," Journal of International Money and Finance, Elsevier, Elsevier, vol. 15(4), pages 535-550, August.
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