Advertisement

Open Economies Review

, Volume 21, Issue 5, pp 679–704 | Cite as

PPP: Delusion or Reality? Evidence from a Nonlinear Analysis

  • Juan A. Jiménez-Martin
  • M. Dolores Robles-FernandezEmail author
Research Article
First Online:

Abstract

In this paper we analyze the validity of the purchasing power parity (PPP) in a nonlinear framework using data for 18 bilateral US dollar exchange rates. Following Enders and Ludlow (2002), we use unit root and cointegration tests that do not assume a specific nonlinear adjustment. We find evidence of non-linear mean reversion in deviations from the PPP equilibrium in 11 out of 18 currencies. Additionally, to disentangle the respective contribution of exchange rate and prices to the adjustment toward the long run equilibrium, we estimate a Vector Error Correction Model. According to our empirical analysis, there exists a nonlinear mechanism to correct for deviation from the PPP equilibrium that comes mainly from the exchange rates. This is consistent with theoretical arguments on international goods markets under transaction costs as well as with an emerging strand of empirical literature. These results highlight the importance of neglecting the possibility of nonlinearity in the debate about the PPP and provide empirical evidence that supports the scenario of the PPP hypothesis as a reality.

Keywords

Unit-root test Cointegration test Fourier approximation Nonlinear VECM Exchange rates Purchasing power parity 

JEL Classification

F31 C22 C32 
This is a preview of subscription content, log in to check access.

Notes

Acknowledgement

We are grateful to A. Novales and two anonymous referees for helpful comments. The paper has benefited of comments from seminar participants at the George Washington University and from participants in the Unit root and Testing Cointegration conference. We acknowledge the financial support of the Ministerio de Ciencia y Tecnología, Spain, through the Project SEJ2006-14354/ECON and the Comunidad de Madrid through the Project 940063.

References

  1. Amara J, Papell D (2006) Testing for purchasing power parity using stationary covariates. Appl Financ Econ 16(1–2):29–39. doi: 10.1080/09603100500389374 CrossRefGoogle Scholar
  2. Baum CF, Barkoulas JT, Caglayan M (2001) Non-linear adjustment to purchasing power parity in the Post-Bretton Woods era. J Int Money Finance 20:379–399CrossRefGoogle Scholar
  3. Bec F, Guay A, Guerre E (2008) Adaptive consistent unit root tests based on autoregressive threshold model. J Econom 142(1):94–133. doi: 10.1016/j.jeconom.2007.05.011 CrossRefGoogle Scholar
  4. Cheung YW, Lai KS, Kon S (1998) Parity reversion in real exchange rates during the post-Bretton Woods period. J Int Money Finance 18:751–768Google Scholar
  5. Cheung YW, Lai KS, Bergman M (2004) Dissecting the PPP puzzle: the unconventional roles of nominal exchange rate and price adjustments. J Int Econ 64:135–150. doi: 10.1016/S0022-1996(03) 00076-X CrossRefGoogle Scholar
  6. Corbae D, Ouliaris S (1988) Cointegration and tests of purchasing power parity. Rev Econ Stat 70:508–521. doi: 10.2307/1926790 CrossRefGoogle Scholar
  7. Davidson R, MacKinnon J (1993) Estimation and inference in econometrics. Oxford University Press, OxfordGoogle Scholar
  8. Diebold F, Husted S, Rush M (1991) Real exchange rate under the gold standard. J Polit Econ 99:1151–1158. doi: 10.1086/261799 CrossRefGoogle Scholar
  9. Dumas B (1992) Dynamic equilibrium and the real exchange rate in a spatially separated world. Rev Financ Stud 5:153–180. doi: 10.1093/rfs/5.2.153 CrossRefGoogle Scholar
  10. Edison HJ, Fisher E (1991) A long-run view of the European monetary system. J Int Money Finance 10:53–70. doi: 10.1016/0261-5606(91)90026-G CrossRefGoogle Scholar
  11. Elliott G, Rothenberg TJ, Stock JH (1996) Efficient tests for an autoregressive unit root. Econometrica 64:813–836. doi: 10.2307/2171846 CrossRefGoogle Scholar
  12. Enders W, Dibooglu S (2001) Long-run purchasing power parity with asymmetric adjustment. South Econ J 68:433–445. doi: 10.2307/1061603 CrossRefGoogle Scholar
  13. Enders W, Siklos PL (2001) Cointegration and Threshold Adjustment. J Bus Econ Stat 19:166–176CrossRefGoogle Scholar
  14. Enders W, Loudlow J (2002) “Non-linear decay: Tests for an attractor using a Fourier approximation.” Working Paper 01-02-02, University of Alabama. http://www.cba.ua.edu/efl/working_papers/pdf/WP01-02-02.pdf
  15. Enders W, Hoover GA (2003) The effect of robust growth on poverty: a nonlinear analysis. Appl Econ 35(9):1063–1071. doi: 10.1080/0003684032000080871 CrossRefGoogle Scholar
  16. Engel C, Morley J (2001) The adjustment of prices and the adjustment of the exchange rate. NBER Google Scholar
  17. Engel CM, Hendrickson MK, Rogers JH (1997) “Intra-National, Intra-Continental, and Intra-Planetary PPP” Board of Governors of the Federal Reserve System International Finance, Discussion Paper 589. doi: 10.2139/ssrn.76928
  18. Engle R, Granger C (1987) Co-integration and error correction: representation, estimation, and testing. Econometrica 55:251–276. doi: 10.2307/1913236 CrossRefGoogle Scholar
  19. Fernández JL, Peruga R (1999) “Un Contraste ADF Secuencial para la Detección de Cambios en la Tendencia Estocástica”, WP 5/99. Universidad Europea, MadridGoogle Scholar
  20. Fernández JL, Robles MD (2008) Time-series model forecasts and structural breaks: evidence from Spanish pre-EMU interest rates. Appl Econ 40(13):1707–1721. doi: 10.1080/00036840600895640 CrossRefGoogle Scholar
  21. Fernández-Serrano JL, Sosvilla S (2003) Modelling the linkages between US and Latin American stock markets. Appl Econ 35(12):1423–1434. doi: 10.1080/0003684032000100409 CrossRefGoogle Scholar
  22. Frankel J, Rose A (1996) A panel project on purchasing power parity: mean reversion within and between countries. J Int Econ 40:209–224. doi: 10.1016/0022-1996(95)01396-2 CrossRefGoogle Scholar
  23. Granger C (1986) Developments in the study of cointegrated variables. Oxf Bull Econ Stat 48:213–228CrossRefGoogle Scholar
  24. Gregory AW, Hansen BE (1996) Residual based tests for cointegration in models with regime shifts. J Econom 70:99–126. doi: 10.1016/0304-4076(69)41685-7 CrossRefGoogle Scholar
  25. Grilli V, Kaminsky G (1991) Nominal exchange rate regimes and the real exchange rate: evidence for the United States and Great Britain, 1885–1986. J Monet Econ 27:191–212. doi: 10.1016/0304-3932(91)90041-L CrossRefGoogle Scholar
  26. Juvenal L, Taylor MP (2007) The law of one price: Nonlinearities in sectoral real exchange rate dynamics. University of WarwickGoogle Scholar
  27. Kapetanios G, Shin A, Snell Y (2003) Testing for a unit root in the nonlinear STAR framework. J Econom 112:359–379. doi: 10.1016/S0304-4076(02)00202-6 CrossRefGoogle Scholar
  28. Kapetanios G, Snell A, Shin Y (2006) Testing for cointegration in nonlinear smooth transition error correction models. Econom Theory 22:279–303. doi: 10.1017/S0266466606060129 CrossRefGoogle Scholar
  29. Koedijk K, Schotman P, Van Dijk M (1998) The re-emergence of PPP in the 1900’s. J Int Money Finance 17:51–61. doi: 10.1016/S0261-5606(97)98051-7 CrossRefGoogle Scholar
  30. Liu PC, Maddala GS (1996) “Do panel data cross-country regressions rescue purchasing power parity (PPP) theory?” Working Paper, Department of Economics, Ohio State UniversityGoogle Scholar
  31. Lothian J (1997) Multi-country evidence on the behaviour of purchasing power parity. J Int Money Finance 16:19–35. doi: 10.1016/S0261-5606(96)00047-2 CrossRefGoogle Scholar
  32. Ludlow J, Enders W (2000) Estimating non linear ARMA models using fourier coefficients. Int J Forecast 70:261–290Google Scholar
  33. MacKinnon JG (1996) Numerical distribution functions for unit root and cointegration tests. J Appl Econ 11:601–618. doi: 10.1002/(SICI)1099-1255(199611)11:6<601::AID-JAE417>3.0.CO;2-T CrossRefGoogle Scholar
  34. Meese R, Rogoff K (1988) Was it real? The exchange rate interest differential relation over the modern floating exchange rate period. J Finance 43:933–948. doi: 10.2307/2328144 CrossRefGoogle Scholar
  35. Michael P, Nobay A, Peel D (1997) Transaction costs and non-linear adjustments in real exchange rates: an empirical investigation. J Polit Econ 105:862–879. doi: 10.1086/262096 CrossRefGoogle Scholar
  36. O’Connell PGJ (1998) The overvaluation of purchasing power parity. J Int Econ 44:1–19. doi: 10.1016/S0022-1996(97)00017-2 CrossRefGoogle Scholar
  37. Oh KY (1996) Purchasing power parity and unit root tests using panel data. J Int Money Finance 15:405–418. doi: 10.1016/0261-5606(96)00012-5 CrossRefGoogle Scholar
  38. Papell DH (1997) Searching for stationarity: purchasing power parity under the current float. J Int Econ 43:313–332. doi: 10.1016/S0022-1996(96)01467-5 CrossRefGoogle Scholar
  39. Papell DH, Theodoridis H (1998) Increasing evidence of purchasing power parity over the current float. J Int Money Finance 17:41–50. doi: 10.1016/S0261-5606(97)00050-8 CrossRefGoogle Scholar
  40. Pedroni P (1997). “Panel cointegration: asymptotic and finite sample properties of pooled time series tests with an application to the PPP hypothesis (new results).” Working paper. Department of Economics, Indiana UniversityGoogle Scholar
  41. Perron P, Rodriguez G (2001) Residual based test for cointegration with GLS detrended data. University of Montreal, PhD dissertationGoogle Scholar
  42. Robles MD, Nieto ML, Fernández A (2004) Nonlinear Intraday dynamics in Eurostoxx50 index markets. Stud Nonlinear Dyn Econom 8(4), art. 3Google Scholar
  43. Rothman P (1998) Forecasting asymmetric unemployment rates. Rev Econ Stat 80:164–168. doi: 10.1162/003465398557276 CrossRefGoogle Scholar
  44. Sercu P, Uppal R, Van Hull C (1995) The exchange rate in the presence of transaction costs: implications for tests of purchasing power parity. J Finance 50:1309–1319. doi: 10.2307/2329354 CrossRefGoogle Scholar
  45. Taylor A (1996) “International capital mobility in history: Purchasing-power parity in the long run.” Working Paper 5742. National Bureau of Economic Research, Cambridge, MAGoogle Scholar
  46. Taylor A, Taylor M (2004) The purchasing power parity debate. J Econ Perspect 18:135–158. doi: 10.1257/0895330042632744 Google Scholar
  47. Uppal R (1993) A general equilibrium model of international portfolio choice. J Finance 48:529–553. doi: 10.2307/2328911 CrossRefGoogle Scholar
  48. Wu Y (1996) Are real exchange rates non-stationary? Evidence from a panel data test. J Money Credit Bank 28:54–63. doi: 10.2307/2077966 CrossRefGoogle Scholar

Copyright information

© Springer Science+Business Media, LLC 2009

Authors and Affiliations

  • Juan A. Jiménez-Martin
    • 1
  • M. Dolores Robles-Fernandez
    • 1
    Email author
  1. 1.Departamento de Fundamentos del Análisis Económico IIUniversidad ComplutensePozuelo de AlarcónSpain

Personalised recommendations

Cite article

Buy options