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Getting PPP Right: Identifying Mean-Reverting Real Exchange Rates in Panels

  • Georgios Chortareas

    ()

    (Bank of England)

  • George Kapetanios

    ()

    (Queen Mary, University of London)

Recent advances in testing for the validity of Purchasing Power Parity (PPP) focus on the time series properties of real exchange rates in panel frameworks. One weakness of such tests, however, is that they fail to inform the researcher as to which cross-section units are stationary. As a consequence, a reservation for PPP analyses based on such tests is that a small number of real exchange rates in a given panel may drive the results. In this paper we examine the PPP hypothesis focusing on the stationarity of the real exchange rates in up to 25 OECD countries. We introduce a methodology that when applied to a set of established panel-unit-root tests, allows to identify the real exchange rates that are stationary and poolable without trading-off any test power. We apply procedures that account for cross-sectional dependence. Our results reveal evidence of mean-reversion that is significantly stronger as compared to those obtained by the existing literature, strengthening the case for PPP. Moreover, our approach allows to provide half-lives estimates for the mean-reverting real exchange rates and so find that the half-lives are shorter than the literature consensus and therefore that the PPP puzzle is less pronounced than initially thought.

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Paper provided by Queen Mary University of London, School of Economics and Finance in its series Working Papers with number 517.

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Date of creation: Jul 2004
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Handle: RePEc:qmw:qmwecw:wp517
Note: A revised version is available as Working Paper 629.
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  1. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  2. Hausman, Jerry A, 1978. "Specification Tests in Econometrics," Econometrica, Econometric Society, vol. 46(6), pages 1251-71, November.
  3. M. Hashem Pesaran, 2007. "A simple panel unit root test in the presence of cross-section dependence," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 22(2), pages 265-312.
  4. Syed A. Basher & Josep Lluís Carrion-i-Silvestre, 2007. "Another Look at the Null of Stationary RealExchange Rates. Panel Data with Structural Breaks and Cross-section Dependence," IREA Working Papers 200710, University of Barcelona, Research Institute of Applied Economics, revised May 2007.
  5. Pesaran, M.H. & Smith, R., 1992. "Estimating Long-Run Relationships From Dynamic Heterogeneous Panels," Cambridge Working Papers in Economics 9215, Faculty of Economics, University of Cambridge.
  6. Papell, David H., 1997. "Searching for stationarity: Purchasing power parity under the current float," Journal of International Economics, Elsevier, vol. 43(3-4), pages 313-332, November.
  7. Ken Froot & Kenneth Rogoff, . "Perspectives on PPP and Long-Run Real Exchange Rates," Working Paper 32027, Harvard University OpenScholar.
  8. Chowdhry, Bhagwan & Roll, Richard & Xia, Yihong, 2004. "Extracting Inflation from Stock Returns to Test Purchasing Power Parity," Working Papers 04-2, University of Pennsylvania, Wharton School, Weiss Center.
  9. Robert E. Cumby, 1996. "Forecasting Exchange Rates and Relative Prices with the Hamburger Standard: Is What You Want What You Get With McParity?," NBER Working Papers 5675, National Bureau of Economic Research, Inc.
  10. Sarno, Lucio & Valente, Giorgio, 2006. "Deviations from purchasing power parity under different exchange rate regimes: Do they revert and, if so, how?," Journal of Banking & Finance, Elsevier, vol. 30(11), pages 3147-3169, November.
  11. Harris, Richard D. F. & Tzavalis, Elias, 1999. "Inference for unit roots in dynamic panels where the time dimension is fixed," Journal of Econometrics, Elsevier, vol. 91(2), pages 201-226, August.
  12. Frankel, Jeffrey A. & Rose, Andrew K., 1996. "A panel project on purchasing power parity: Mean reversion within and between countries," Journal of International Economics, Elsevier, vol. 40(1-2), pages 209-224, February.
  13. Yoosoon Chang, 2000. "Nonlinear IV Unit Root Tests in Panels with Cross-Sectional Dependency," CIRJE F-Series CIRJE-F-85, CIRJE, Faculty of Economics, University of Tokyo.
  14. Westerlund, Joakim & Larsson, Rolf, 2009. "A Note On The Pooling Of Individual Panic Unit Root Tests," Econometric Theory, Cambridge University Press, vol. 25(06), pages 1851-1868, December.
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  17. Georgios Chortareas & George Kapetanios, 2003. "The Yen Real Exchange Rate May Be Stationary after All: Evidence from Nonlinear Unit-Root Tests," Working Papers 484, Queen Mary University of London, School of Economics and Finance.
  18. Papell, David H. & Theodoridis, Hristos, 1998. "Increasing evidence of purchasing power parity over the current float," Journal of International Money and Finance, Elsevier, vol. 17(1), pages 41-50, February.
  19. Georgios Chortareas & George Kapetanios, 2008. "Getting PPP Right: Identifying Mean-Reverting Real Exchange Rates in Panels," Working Papers 629, Queen Mary University of London, School of Economics and Finance.
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  23. Hakkio, Craig S., 1984. "A re-examination of purchasing power parity : A multi-country and multi-period study," Journal of International Economics, Elsevier, vol. 17(3-4), pages 265-277, November.
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  25. Serletis, Apostolos & Gogas, Periklis, 2004. "Long-horizon regression tests of the theory of purchasing power parity," Journal of Banking & Finance, Elsevier, vol. 28(8), pages 1961-1985, August.
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  27. Oh, Keun-Yeob, 1996. "Purchasing power parity and unit root tests using panel data," Journal of International Money and Finance, Elsevier, vol. 15(3), pages 405-418, June.
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  35. Lyhagen, Johan, 2000. "Why not use standard panel unit root test for testing PPP," SSE/EFI Working Paper Series in Economics and Finance 413, Stockholm School of Economics.
  36. Ziemer, Rod F. & Wetzstein, Michael E., 1983. "A Stein-rule method for pooling data," Economics Letters, Elsevier, vol. 11(1-2), pages 137-143.
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