The overvaluation of PPP in Europe?
This paper tests for long run PPP using a nonstationary panel regression framework that can accommodate both permanent and temporary shocks. It also uses the common correlated estimator of Pesaran (2003a) to take account of cross sectional dependence. The PPP null in our framework is a unit elasticity of nominal exchange rates with respect to relative prices. Using US dollar and German mark spot rates and the consumer price index for 15 European economies 1977:1-2001:12, we cannot reject the hypothesis that the long run relative price elasticity of exchange rates is unity. While this result supports long run PPP in our European sample, it has to be viewed with caution since some residual cross sectional dependence remains.
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