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PPP May not Hold Afterall: A Further Investigation

  • Serena Ng

    ()

    (Department of Economics, Johns Hopkins University)

  • Pierre Perron

    ()

    (Department of Economics, Boston University)

In a recent paper, Engel, C. (1999) presents monte-carlo evidence to suggest that unit root tests cannot detect a non-stationary component in the real exchange rate even when this component accounts for almost half of its longhorizon forecast error variance. This hidden non-stationary component led to the conclusion that long run purchasing power parity might not hold afterall. In this note, we first point out some conceptual difficulties with the statistic being used to measure the size of the non-stationary component, and then argue that it bears no systematic relationship with rejection rates in unit root tests. The problems stem from near observational equivalence of the simulated model in not one, but two dimensions. We then discuss the steps a practitioner can take to minimize Type I error in cases when the non-stationary component is hard to detect. Real exchange rate data for 19 countries are examined and estimates are obtained for the duration of the real exchange rate shocks.

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Paper provided by China Economics and Management Academy, Central University of Finance and Economics in its series CEMA Working Papers with number 83.

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Length: 22 pages
Date of creation: May 2002
Date of revision:
Publication status: Published in Annals of Economics and Finance, May 2002, pages 43-64
Handle: RePEc:cuf:wpaper:83
Contact details of provider: Web page: http://cema.cufe.edu.cn/

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  1. Perron, P. & Ng, S., 1994. "Useful Modifications to Some Unit Root Tests with Dependent Errors and Their Local Asymptotic Properties," Cahiers de recherche 9427, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  2. Engel, C., 1996. "Accounting for U.S. Real Exchange Rate Changes," Discussion Papers in Economics at the University of Washington 96-02, Department of Economics at the University of Washington.
  3. Perron, P. & Ng, S., 1996. "An Autoregressive Spectral Density Estimator at Frequency Zero for Nonstationarity Tests," Cahiers de recherche 9611, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  4. Perron, Pierre, 1996. "The adequacy of asymptotic approximations in the near-integrated autoregressive model with dependent errors," Journal of Econometrics, Elsevier, vol. 70(2), pages 317-350, February.
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  7. Nabeya, Seiji & Perron, Pierre, 1994. "Local asymptotic distribution related to the AR(1) model with dependent errors," Journal of Econometrics, Elsevier, vol. 62(2), pages 229-264, June.
  8. Schwert, G William, 1989. "Tests for Unit Roots: A Monte Carlo Investigation," Journal of Business & Economic Statistics, American Statistical Association, vol. 7(2), pages 147-59, April.
  9. Serena Ng & Pierre Perron, 1997. "Lag Length Selection and the Construction of Unit Root Tests with Good Size and Power," Boston College Working Papers in Economics 369, Boston College Department of Economics, revised 01 Sep 2000.
  10. Laurence Ball & Robert Moffitt, 2001. "Productivity Growth and the Phillips Curve," NBER Working Papers 8421, National Bureau of Economic Research, Inc.
  11. Shiller, Robert J. & Perron, Pierre, 1985. "Testing the random walk hypothesis : Power versus frequency of observation," Economics Letters, Elsevier, vol. 18(4), pages 381-386.
  12. Hamori, Shigeyuki & Tokihisa, Akira, 1997. "Testing for a unit root in the presence of a variance shift1," Economics Letters, Elsevier, vol. 57(3), pages 245-253, December.
  13. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
  14. Bergin, Paul R. & Feenstra, Robert C., 2001. "Pricing-to-market, staggered contracts, and real exchange rate persistence," Journal of International Economics, Elsevier, vol. 54(2), pages 333-359, August.
  15. John Y. Campbell & Pierre Perron, 1991. "Pitfalls and Opportunities: What Macroeconomists Should Know About Unit Roots," NBER Chapters, in: NBER Macroeconomics Annual 1991, Volume 6, pages 141-220 National Bureau of Economic Research, Inc.
  16. Gordon, Robert J, 1996. "The Time-varying NAIRU and its Implications for Economic Policy," CEPR Discussion Papers 1492, C.E.P.R. Discussion Papers.
  17. John B. Taylor, 1999. "A Historical Analysis of Monetary Policy Rules," NBER Chapters, in: Monetary Policy Rules, pages 319-348 National Bureau of Economic Research, Inc.
  18. Robert J. Gordon, 1998. "Foundations of the Goldilocks Economy: Supply Shocks and the Time-Varying NAIRU," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 297-346.
  19. Ng, S. & Perron, P., 1995. "Estimation and Inference in Nearly Unbalanced, Nearly Cointegrated Systems," Cahiers de recherche 9534, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  20. Cochrane, John H., 1991. "A critique of the application of unit root tests," Journal of Economic Dynamics and Control, Elsevier, vol. 15(2), pages 275-284, April.
  21. Faust, Jon, 1996. "Near Observational Equivalence and Theoretical size Problems with Unit Root Tests," Econometric Theory, Cambridge University Press, vol. 12(04), pages 724-731, October.
  22. 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.
  23. Clark, Peter K., 1988. "Nearly redundant parameters and measures of persistence in economic time series," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 447-461.
  24. Robert R Tchaidze, 2001. "Estimating Taylor Rules in a Real Time Setting," Economics Working Paper Archive 457, The Johns Hopkins University,Department of Economics.
  25. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  26. Douglas Staiger & James H. Stock & Mark W. Watson, 1997. "The NAIRU, Unemployment and Monetary Policy," Journal of Economic Perspectives, American Economic Association, vol. 11(1), pages 33-49, Winter.
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