Purchasing Power Parity: the Choice of Price Index
Looking closely at the PPP argument, it states that the currencies purchasing power should not change when comparing the same basket goods across countries, and these goods should all be tradable. Hence, if PPP is valid at all, it should be captured by the relative price indices that best fits these two features. We ran a horse race among six different price indices available from the IMF database to see which one would yield higher PPP evidence, and, therefore, better fit the two features. We used RER proxies measured as the ratio of export unit values, wholesale prices, value added deflators, unit labor costs, normalized unit labor costs and consumer prices, for a sample of 16 industrial countries, with quarterly data from 1975 to 2002. PPP was tested using both the ADF and the DF-GLS unit root test of the RER series. The RER measured as WPI ratios was the one for which PPP evidence was found for the larger number of countries: six out of sixteen. The worst measure of all was the RER based on the ratio of foreign CPIs and domestic WPI. No evidence of PPP at all was found for this measure
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