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Uncover Latent PPP by Dynamic Factor Error Correction Model (DF-ECM) Approach: Evidence from Five OECD Countries

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Duo Qin () (Queen Mary, University of London)

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Abstract

This study measures purchasing power parity (PPP) by means of the dynamic-factor errorcorrection model (DF-ECM) approach. Under this new approach, PPP is embedded in latent disequilibrium factors, which are extracted from a large variable set of bilateral price disparities; the factors are then used as error-correction leading indicators to explain exchange rate and inflation. Modelling experiments on five OECD countries using monthly data show promising results, which reverse the common belief that PPP is at best a very long-run relationship at the macro level.

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Paper provided by Queen Mary, University of London, Department of Economics in its series Working Papers with number 575.

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Date of creation: Sep 2006
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Handle: RePEc:qmw:qmwecw:wp575

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Related research
Keywords: Purchasing power parity Law of one price Dynamic factor Error correction

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models
C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data

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  1. Menzie D. Chinn, 2005. "A Primer on Real Effective Exchange Rates: Determinants, Overvaluation, Trade Flows and Competitive Devaluation," NBER Working Papers 11521, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Jean Imbs & Haroon Mumtaz & Morten Ravn & Hélène Rey, 2005. "PPP Strikes Back: Aggregation and the Real Exchange Rate," The Quarterly Journal of Economics, MIT Press, vol. 120(1), pages 1-43, January.
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  3. Alexei Onatski, 2005. "Determining the number of factors from empirical distribution of eigenvalues," Discussion Papers 0405-19, Columbia University, Department of Economics. [Downloadable!]
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