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Spatial considerations on the PPP debate

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  • Ca' Zorzi, Michele
  • Chudik, Alexander

Abstract

This paper studies the influence of aggregating across space when (i) testing the PPP theory or more generally pair-wise cointegration and (ii) evaluating the PPP puzzle. Our contribution is threefold: we show that aggregating foreign data and applying an ADF test may lead to erroneously reject the PPP hypothesis. We then show, on the basis of theoretical arguments as well as Monte Carlo experiments, that a sizable bias in the estimates of half-life deviations to PPP may be due to the effect of aggregation across space. We finally illustrate empirically the importance of spatial considerations when estimating the speed of price convergence among euro area countries. JEL Classification: C23, F41

Suggested Citation

  • Ca' Zorzi, Michele & Chudik, Alexander, 2013. "Spatial considerations on the PPP debate," Working Paper Series 1534, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20131534
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    References listed on IDEAS

    as
    1. Jean Imbs & Haroon Mumtaz & Morten O. Ravn & Hélène Rey, 2005. "PPP Strikes Back: Aggregation And the Real Exchange Rate," The Quarterly Journal of Economics, Oxford University Press, vol. 120(1), pages 1-43.
    2. Charles Engel & Nelson C. Mark & Kenneth D. West, 2008. "Exchange Rate Models Are Not As Bad As You Think," NBER Chapters,in: NBER Macroeconomics Annual 2007, Volume 22, pages 381-441 National Bureau of Economic Research, Inc.
    3. Chambers, Marcus J., 2005. "The purchasing power parity puzzle, temporal aggregation, and half-life estimation," Economics Letters, Elsevier, vol. 86(2), pages 193-198, February.
    4. Alexander Chudik & M. Hashem Pesaran & Elisa Tosetti, 2011. "Weak and strong cross‐section dependence and estimation of large panels," Econometrics Journal, Royal Economic Society, vol. 14(1), pages 45-90, February.
    5. M. Hashem Pesaran & Ron Smith & Takashi Yamagata & Lyudmyla Hvozdyk, 2009. "Pairwise Tests of Purchasing Power Parity," Econometric Reviews, Taylor & Francis Journals, vol. 28(6), pages 495-521.
    6. Choi, Chi-Young & Mark, Nelson C. & Sul, Donggyu, 2006. "Unbiased Estimation of the Half-Life to PPP Convergence in Panel Data," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(4), pages 921-938, June.
    7. Michele Ca’ Zorzi & Michal Rubaszek, 2012. "Real exchange rate forecasting: a calibrated half-life PPP model can beat the random walk," NBP Working Papers 123, Narodowy Bank Polski, Economic Research Department.
    8. Serena Ng & Pierre Perron, 2001. "LAG Length Selection and the Construction of Unit Root Tests with Good Size and Power," Econometrica, Econometric Society, vol. 69(6), pages 1519-1554, November.
    9. Benigno, Gianluca & Benigno, Pierpaolo, 2008. "Exchange rate determination under interest rate rules," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 971-993, October.
    10. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-1580, November.
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    More about this item

    Keywords

    aggregation across space; cointegration; Half-life estimates; PPP; price convergence;

    JEL classification:

    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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