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Is there a rule of thumb for absolute purchasing power parity to hold?

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  • Zhang, Zhibai

Abstract

We find an example where real exchange rate (RER) is stationary and the nominal exchange rate and the price levels are cointegrated but purchasing power parity (PPP) does not hold, which reveals a fault of the unit root and cointegration tests in this use. We argue that the distribution of an RER misalignment can be used in testing absolute PPP. Then we apply this new test and the coefficient restriction test to study the validity of absolute PPP in 40 main countries and areas (versus the US) in light of the Harrod-Balassa-Samuelson effect. The econometric proofs show that absolute PPP holds or closely holds in most countries when their averaged relative GDP per capita (GDPPs, against the US with the US = 1) are greater than 0.7. And it does not hold in almost all countries when their averaged GDPPs are smaller than 0.7. Thus, a rule of thumb for the theory to hold is that the GDPP should be above 0.7.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 55338.

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Date of creation: 14 Apr 2014
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Handle: RePEc:pra:mprapa:55338

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Keywords: Absolute purchasing power parity; Real exchange rate; RER misalignment distribution test; Harrod-Balassa-Samuelson effect;

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  1. Alan M. Taylor & Mark P. Taylor, 2004. "The Purchasing Power Parity Debate," NBER Working Papers 10607, National Bureau of Economic Research, Inc.
  2. Charles Engel, 1998. "Long-Run PPP May Not Hold After All," Working Papers, University of Washington, Department of Economics 0050, University of Washington, Department of Economics.
  3. Frenkel, Jacob A., 1981. "The collapse of purchasing power parities during the 1970's," European Economic Review, Elsevier, Elsevier, vol. 16(1), pages 145-165.
  4. Yin-Wong Cheung & Menzie D. Chinn & Antonio Garcia Pascual, 2002. "Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?," NBER Working Papers 9393, National Bureau of Economic Research, Inc.
  5. Pablo Astorga, 2010. "Mean Reversion in Long-Horizon Real Exchange Rates: Evidence from Latin America," Economics Series Working Papers, University of Oxford, Department of Economics Number 80, University of Oxford, Department of Economics.
  6. Edison, Hali J. & Gagnon, Joseph E. & Melick, William R., 1997. "Understanding the empirical literature on purchasing power parity: the post-Bretton Woods era," Journal of International Money and Finance, Elsevier, Elsevier, vol. 16(1), pages 1-17, February.
  7. Taylor, Mark P & Peel, David A & Sarno, Lucio, 2001. "Nonlinear Mean-Reversion in Real Exchange Rates: Toward a Solution to the Purchasing Power Parity Puzzles," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(4), pages 1015-42, November.
  8. Pedroni, Peter, 2004. "Panel Cointegration: Asymptotic And Finite Sample Properties Of Pooled Time Series Tests With An Application To The Ppp Hypothesis," Econometric Theory, Cambridge University Press, Cambridge University Press, vol. 20(03), pages 597-625, June.
  9. Lothian, James R & Taylor, Mark P, 1996. "Real Exchange Rate Behavior: The Recent Float from the Perspective of the Past Two Centuries," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(3), pages 488-509, June.
  10. Ito, Takatoshi, 1997. "The Long-Run Purchasing Power Parity for the Yen: Historical Overview," Journal of the Japanese and International Economies, Elsevier, vol. 11(4), pages 502-521, December.
  11. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, American Economic Association, vol. 34(2), pages 647-668, June.
  12. Chang, Tsangyao & Tzeng, Han-Wen, 2011. "Long-run purchasing power parity with asymmetric adjustment: Further evidence from nine transition countries," Economic Modelling, Elsevier, Elsevier, vol. 28(3), pages 1383-1391, May.
  13. Peter Isard, 2007. "Equilibrium Exchange Rates," IMF Working Papers, International Monetary Fund 07/296, International Monetary Fund.
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