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PPP May not Hold After all: A Further Investigation

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  • Serena Ng
  • Pierre Perron

Abstract

In a recent paper Engel (1999b) presents monte-carlo evidence to suggest that unit root tests can not detect a non-stationary component in the real exchange rate even when this component accounts for almost half of its long-horizon forecast error variance This hidden non-stationary component led to the conclusion that long run purchasing power parity might not hold after all In this note we first point out some conceptual difficulties with the statistic being used to measure the size of the non-stationary component and then argue that it bears no systematic relationship with rejection rates in unit root tests The problems stem from near observational equivalence of the simulated model in not one but two dimensions We then discuss the steps a practitioner can take to minimize Type I error in cases when the non-stationary component is hard to detect Real exchange rate data for 19 countries are examined and estimates are obtained for the duration of the real exchange rate shocks

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Bibliographic Info

Paper provided by The Johns Hopkins University,Department of Economics in its series Economics Working Paper Archive with number 466.

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Date of creation: Feb 2001
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Handle: RePEc:jhu:papers:466

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References

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  1. Robert J. Shiller & Pierre Perron, 1985. "Testing the Random Walk Hypothesis: Power versus Frequency of Observation," NBER Technical Working Papers 0045, National Bureau of Economic Research, Inc.
  2. John B. Taylor, 1999. "A Historical Analysis of Monetary Policy Rules," NBER Chapters, in: Monetary Policy Rules, pages 319-348 National Bureau of Economic Research, Inc.
  3. Cochrane, John H., 1991. "A critique of the application of unit root tests," Journal of Economic Dynamics and Control, Elsevier, vol. 15(2), pages 275-284, April.
  4. Ng, S. & Perron, P., 1995. "Estimation and Inference in Nearly Unbalanced, Nearly Cointegrated Systems," Cahiers de recherche 9534, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  5. Perron, P., 1994. "The Adequacy of Asymptotic Approximations in the Near-Integrated Autoregressive Model with Dependent Errors," Cahiers de recherche 9424, Universite de Montreal, Departement de sciences economiques.
  6. Nabeya, Seiji & Perron, Pierre, 1994. "Local asymptotic distribution related to the AR(1) model with dependent errors," Journal of Econometrics, Elsevier, vol. 62(2), pages 229-264, June.
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  8. Robert R Tchaidze, 2001. "Estimating Taylor Rules in a Real Time Setting," Economics Working Paper Archive 457, The Johns Hopkins University,Department of Economics.
  9. Laurence Ball & Robert Moffitt, 2001. "Productivity Growth and the Phillips Curve," Economics Working Paper Archive 450, The Johns Hopkins University,Department of Economics.
  10. Campbell, J.Y. & Perron, P., 1991. "Pitfalls and Opportunities: What Macroeconomics should know about unit roots," Papers 360, Princeton, Department of Economics - Econometric Research Program.
  11. Perron, Pierre & Ng, Serena, 1996. "Useful Modifications to Some Unit Root Tests with Dependent Errors and Their Local Asymptotic Properties," Review of Economic Studies, Wiley Blackwell, vol. 63(3), pages 435-63, July.
  12. Robert Feenstra & Paul Bergin, 2003. "Pricing To Market, Staggered Contracts, And Real Exchange Rate Persistence," Working Papers 991, University of California, Davis, Department of Economics.
  13. Elliott, Graham & Rothenberg, Thomas J & Stock, James H, 1996. "Efficient Tests for an Autoregressive Unit Root," Econometrica, Econometric Society, vol. 64(4), pages 813-36, July.
  14. Robert J. Gordon, 1997. "The Time-Varying NAIRU and its Implications for Economic Policy," NBER Working Papers 5735, National Bureau of Economic Research, Inc.
  15. Perron, P. & Ng, S., 1996. "An Autoregressive Spectral Density Estimator at Frequency Zero for Nonstationarity Tests," Cahiers de recherche 9611, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  16. Engel, C., 1996. "Accounting for U.S. Real Exchange Rate Changes," Working Papers 96-02, University of Washington, Department of Economics.
  17. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.).
  18. Hamori, Shigeyuki & Tokihisa, Akira, 1997. "Testing for a unit root in the presence of a variance shift1," Economics Letters, Elsevier, vol. 57(3), pages 245-253, December.
  19. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
  20. Douglas Staiger & James H. Stock & Mark W. Watson, 1996. "How Precise are Estimates of the Natural Rate of Unemployment?," NBER Working Papers 5477, National Bureau of Economic Research, Inc.
  21. Perron, P., 1989. "Test Consistency With Varying Sampling Frequency," Papers 345, Princeton, Department of Economics - Econometric Research Program.
  22. Robert J. Gordon, 1998. "Foundations of the Goldilocks Economy: Supply Shocks and the Time-Varying NAIRU," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 297-346.
  23. Serena Ng & Pierre Perron, 1997. "Lag Length Selection and the Construction of Unit Root Tests with Good Size and Power," Boston College Working Papers in Economics 369, Boston College Department of Economics, revised 01 Sep 2000.
  24. Faust, Jon, 1996. "Near Observational Equivalence and Theoretical size Problems with Unit Root Tests," Econometric Theory, Cambridge University Press, vol. 12(04), pages 724-731, October.
  25. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  26. Clark, Peter K., 1988. "Nearly redundant parameters and measures of persistence in economic time series," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 447-461.
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Citations

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Cited by:
  1. Gawon Yoon, 2003. "The time series behaviour of Brazilian inflation rate: new evidence from unit root tests with good size and power," Applied Economics Letters, Taylor & Francis Journals, vol. 10(10), pages 627-631.
  2. Sofiane H. Sekioua, 2004. "Real interest parity (RIP) over the 20th century: New evidence based on confidence intervals for the dominant root and half-lives of shocks," Money Macro and Finance (MMF) Research Group Conference 2004 91, Money Macro and Finance Research Group.
  3. Alan M. Taylor, 2000. "A Century of Purchasing-Power Parity," NBER Working Papers 8012, National Bureau of Economic Research, Inc.
  4. Seung Hyun Hong & Peter C. B. Phillips, 2005. "Testing Linearity in Cointegrating Relations with an Application to Purchasing Power Parity," Cowles Foundation Discussion Papers 1541, Cowles Foundation for Research in Economics, Yale University.
  5. Philip Hans Franses & Dick van Dijk, 2006. "A simple test for PPP among traded goods," Applied Financial Economics, Taylor & Francis Journals, vol. 16(1-2), pages 19-27.
  6. Maican, Florin G. & Sweeney, Richard J., 2013. "Real exchange rate adjustment in European transition countries," Journal of Banking & Finance, Elsevier, vol. 37(3), pages 907-926.
  7. De-Chih Liu, 2011. "Hysteresis Hypothesis in Job Creation and Destruction: Evidence from the U.S," Annals of Economics and Finance, Society for AEF, vol. 12(2), pages 389-409, November.
  8. Mazzotta, Stefano, 2008. "How important is asymmetric covariance for the risk premium of international assets?," Journal of Banking & Finance, Elsevier, vol. 32(8), pages 1636-1647, August.
  9. Lee, Hwa-Taek & Yoon, Gawon, 2007. "Does Purchasing Power Parity Hold Sometimes? Regime Switching in Real Exchange Rates," Economics Working Papers 2007,24, Christian-Albrechts-University of Kiel, Department of Economics.
  10. Christoph Fischer & Daniel Porath, 2010. "A reappraisal of the evidence on PPP: a systematic investigation into MA roots in panel unit root tests and their implications," Empirical Economics, Springer, vol. 39(3), pages 767-792, December.

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