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On the empirical failure of purchasing power parity tests

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  • Matteo Pelagatti

    ()
    (Dipartimento di Statistica, Università degli Studi di Milano-Bicocca)

  • Emilio Colombo

    ()
    (Dipartimento di Economia, Università degli Studi di Milano-Bicocca)

Abstract

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 prices.

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File URL: http://www.statistica.unimib.it/utenti/WorkingPapers/WorkingPapers/20120501.pdf
File Function: First version, 2012
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Bibliographic Info

Paper provided by Università degli Studi di Milano-Bicocca, Dipartimento di Statistica in its series Working Papers with number 20120501.

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Length: 23 pages
Date of creation: 03 May 2012
Date of revision:
Handle: RePEc:mis:wpaper:20120501

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Related research

Keywords: Purchasing power parity; Law of one price; Stationarity; Unit root;

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References

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  1. Mario Crucini & Chris Telmer & Marios Zachariadis, . "Understanding European Real Exchange Rates," GSIA Working Papers 227, Carnegie Mellon University, Tepper School of Business.
  2. Imbs, Jean & Mumtaz, Haroon & Ravn, Morten O. & Rey, Hélène, 2003. "PPP Strikes Back: Aggregation and the Real Exchange Rate," CEPR Discussion Papers 3715, C.E.P.R. Discussion Papers.
  3. Mario J. Crucini & Mototsugu Shintani, 2006. "Persistence in Law-Of-One-Price Deviations: Evidence from Micro-Data," Vanderbilt University Department of Economics Working Papers 0616, Vanderbilt University Department of Economics.
  4. Elliott, Graham & Pesavento, Elena, 2006. "On the Failure of Purchasing Power Parity for Bilateral Exchange Rates after 1973," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(6), pages 1405-1430, September.
  5. Claude Lopez & Christian J. Murray & David H. Papell, 2004. "State of the Art Unit Root Tests and Purchasing Power Parity," University of Cincinnati, Economics Working Papers Series 2004-04, University of Cincinnati, Department of Economics.
  6. Sarno, Lucio & Taylor, Mark P. & Chowdhury, Ibrahim, 2004. "Nonlinear dynamics in deviations from the law of one price: a broad-based empirical study," Journal of International Money and Finance, Elsevier, vol. 23(1), pages 1-25, February.
  7. Ullah, Aman, 2004. "Finite Sample Econometrics," OUP Catalogue, Oxford University Press, edition 1, number 9780198774488.
  8. Robert J. Hill, 1999. "Comparing Price Levels across Countries Using Minimum-Spanning Trees," The Review of Economics and Statistics, MIT Press, vol. 81(1), pages 135-142, February.
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