Unpuzzling the Purchasing Power Parity Puzzle
AbstractThe empirical validation of the purchasing power parity (PPP) theory is generally based on real exchange rates built using consumer price indexes (CPI). The empirical evidence does not generally support the theory and this fact goes under the name of purchasing power parity puzzle. In this paper we show by theoretical arguments that, even if the law of one price holds for all the goods traded in two countries, real exchange rates based on CPI are not mean-reverting and therefore statistical tests based on them should reject the PPP hypothesis. We prove that such real exchange rates are neither stationary nor integrated, and so both unit-root and stationarity tests should reject the null according to their power properties. The performance of the most common unit-root and stationarity tests in situations in which the law of one price holds is studied by means of a simulation experiment, based on real European CPI weights and price behaviours.
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Bibliographic InfoPaper provided by University of Milano-Bicocca, Department of Economics in its series Working Papers with number 221.
Length: 19 pages
Date of creation: Mar 2012
Date of revision: Mar 2012
Purchasing power parity; Law of one price; Stationarity; Unit root.;
Find related papers by JEL classification:
- C30 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - General
- C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models &bull Diffusion Processes
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