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Pairwise Tests of Purchasing Power Parity Using Aggregate and Disaggregate Price Measures

  • M. Hashem Pesaran
  • Ron P. Smith
  • Takashi Yamagata
  • Liudmyla Hvozdyk

In this paper we adopt a new approach to testing for purchasing power parity, PPP, that is robust to base country effects, cross-section dependence, and aggregation. Given data on N +1 countries, i, j = 0, 1, 2, ..., N, the standard procedure is to apply unit root or stationarity tests to N relative prices against a base country, 0, e.g. the US. The evidence is that such tests are sensitive to the choice of base country. In addition, the analysis is subject to a high degree of cross section dependence which is difficult to deal with particularly when N is large. In this paper we test for PPP applying a pairwise approach to the disaggregated data set recently analysed by Imbs, Mumtaz, Ravan and Rey (2005, QJE). We consider a variety of tests applied to all possible N(N +1)/2 pairs of real exchange rate pairs between the N + 1 countries and estimate the proportion of the pairs that are stationary, for the aggregates and each of the 19 commodity groups. This approach is invariant to base country effects and the proportion that are non-stationary can be consistently estimated even if there is cross-sectional dependence. To deal with small sample problems and residual cross section dependence, we use a factor augmented sieve bootstrap approach and present bootstrap pairwise estimates of the proportions that are stationary. The bootstrapped rejection frequencies at 26%-49% based on unit root tests suggest some evidence in favour of the PPP in the case of the disaggregate data as compared to 6%-14% based on aggregate price series.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1704.

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Date of creation: 2006
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Handle: RePEc:ces:ceswps:_1704
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  1. Hashem Pesaran, M., 2007. "A pair-wise approach to testing for output and growth convergence," Journal of Econometrics, Elsevier, vol. 138(1), pages 312-355, May.
  2. Novy, Dennis, 2006. "Is the Iceberg Melting Less Quickly? International Trade Costs after World War II," The Warwick Economics Research Paper Series (TWERPS) 764, University of Warwick, Department of Economics.
  3. Kwiatkowski, Denis & Phillips, Peter C. B. & Schmidt, Peter & Shin, Yongcheol, 1992. "Testing the null hypothesis of stationarity against the alternative of a unit root : How sure are we that economic time series have a unit root?," Journal of Econometrics, Elsevier, vol. 54(1-3), pages 159-178.
  4. James E. Anderson & Eric van Wincoop, 2004. "Trade Costs," NBER Working Papers 10480, National Bureau of Economic Research, Inc.
  5. Yin-wong Cheung & Kon S. Lai & Michael Bergman, 2003. "Dissecting the PPP Puzzle: The Unconventional Roles of Nominal Exchange Rate and Price Adjustments," Working Papers 102003, Hong Kong Institute for Monetary Research.
  6. Stephane Dees & Filippo di Mauro & M. Hashem Pesaran & L. Vanessa Smith, 2004. "Exploring the International Linkages of the Euro Area: A Global VAR Analysis," IEPR Working Papers 04.6, Institute of Economic Policy Research (IEPR).
  7. Alan M. Taylor & Mark Taylor, 2004. "The Purchasing Power Parity Debate," Working Papers 46, University of California, Davis, Department of Economics.
  8. De Grauwe, Paul & Grimaldi, Marianna, 2006. "Exchange rate puzzles: A tale of switching attractors," European Economic Review, Elsevier, vol. 50(1), pages 1-33, January.
  9. repec:oup:qjecon:v:120:y:2005:i:1:p:1-43 is not listed on IDEAS
  10. Garratt, Anthony & Lee, Kevin & Pesaran, M. Hashem & Shin, Yongcheol, 2012. "Global and National Macroeconometric Modelling: A Long-Run Structural Approach," OUP Catalogue, Oxford University Press, number 9780199650460, July.
  11. Elliott, Graham & Rothenberg, Thomas J & Stock, James H, 1996. "Efficient Tests for an Autoregressive Unit Root," Econometrica, Econometric Society, vol. 64(4), pages 813-36, July.
  12. Michael, Panos & Nobay, A Robert & Peel, David A, 1997. "Transactions Costs and Nonlinear Adjustment in Real Exchange Rates: An Empirical Investigation," Journal of Political Economy, University of Chicago Press, vol. 105(4), pages 862-79, August.
  13. M. Hashem Pesaran, 2004. "Estimation and Inference in Large Heterogeneous Panels with a Multifactor Error Structure," CESifo Working Paper Series 1331, CESifo Group Munich.
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