A Test of Long-Run Purchasing Power Parity Allowing for Structural Breaks
If exchange rates and prices are integrated processes, standard econometric tests of the purchasing power parity (PPP) hypothesis may be biased toward rejection. This paper avoids this problem by using the Engle and Granger (1987) theory of cointegrated processes. If the absolute version of purchasing power parity it true, and nominal exchange rates and prices are integrated processes, intercommodity arbitrage should ensure that the real exchange rate is stationary. The stationarity hypothesis is tested using Australian real exchange rate data for the 1890-1984 period. We find that the effective real exchange rate cannot be modelled as a stationary process and therefore reject the absolute version of PPP. We also employ a test for structural breaks due to, for instance, the oil price shock and find mixed results. Another interpretation of our results is that the real exchange rate was affected by a series of permanent, real shocks during the sample period. Copyright 1991 by The Economic Society of Australia.
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Volume (Year): 67 (1991)
Issue (Month): 196 (March)
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