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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-Fernandez
Research Article

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 

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.

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Copyright information

© Springer Science+Business Media, LLC 2009

Authors and Affiliations

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

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