This paper analyzes purchasing power parity (PPP) for the euro area. We study the impact of the introduction of the euro in 1999 on the behavior of real exchange rates. We test the PPP hypothesis for a panel of real exchange rates within the euro area over the period 1973-2003. Our methodology exploits the cross-sectional dependence across real exchange rates and allows for heterogeneity in the rates of mean reversion. We present evidence in favor of PPP for the full panel of real exchange rates, but we show that accounting for cross-country differences within the euro area is essential. The unit root hypothesis can be rejected for some real exchange rates, but evidence for PPP is weak for others. We also investigate PPP between the "synthetic" euro against several other major currencies over the period 1979-2003. We find support for the PPP hypothesis for the full panel of real exchange rates. When the restriction of a common mean reversion coefficient is relaxed, we reject the unit root hypothesis for the euroSwiss franc rate only. We conclude that the process of economic integration in Europe has accelerated convergence toward PPP within the euro area. This paper analyzes purchasing power parity (PPP) for the euro area. We study the impact of the introduction of the euro in 1999 on the behavior of real exchange rates. We test the PPP hypothesis for a panel of real exchange rates within the euro area over the period 1973-2003. Our methodology exploits the cross-sectional dependence across real exchange rates and allows for heterogeneity in the rates of mean reversion. We present evidence in favor of PPP for the full panel of real exchange rates, but we show that accounting for cross-country differences within the euro area is essential. The unit root hypothesis can be rejected for some real exchange rates, but evidence for PPP is weak for others. We also investigate PPP between the "synthetic" euro against several other major currencies over the period 1979-2003. We find support for the PPP hypothesis for the full panel of real exchange rates. When the restriction of a common mean reversion coefficient is relaxed, we reject the unit root hypothesis for the euro-Swiss franc rate only. We conclude that the process of economic integration in Europe has accelerated convergence toward PPP within the euro area. 5001-6182 Business. H\ZRUGVEuropean integration, real exchange rates, purchasing power parity, heterogeneous SUR

In this paper we present a parsimonious multivariate model for exchange rate volatilities based on logarithmic high-low ranges of daily exchange rates. The multivariate stochastic volatility model decomposes the log range of each exchange rate into two independent latent factors, which could be interpreted as the underlying currency specific components. Owing to the empirical normality of the logarithmic range measure the model can be estimated conveniently with the standard Kalman filter methodology. Our results show that our model fits the exchange rate data quite well. Exchange rate news seems to be currency specific and allows identification of currency contributions to both exchange rate levels and exchange rate volatilities.Exchange rates, Multivariate stochastic volatility models, Range-based volatility,

JEL classification: F31 F33 F47 Keywords: PPP Real exchange rates Panel models Unit root tests Heterogeneity Panel tests a b s t r a c tRecent studies of purchasing power parity (PPP) use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates. In contrast to several other severe restrictions of panel models and tests of PPP, the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. This paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies. Using Monte Carlo simulation, we uncover important adverse properties of the panel approach that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. These properties can lead to misleading inferences on the validity of PPP. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

Recent studies of purchasing power parity (PPP) use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates. In contrast to several other severe restrictions of panel models and tests of PPP, the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. This paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies. Using Monte Carlo simulation, we uncover important adverse properties of the panel approach that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. These properties can lead to misleading inferences on the validity of PPP. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

Prior studies show that extreme interest rate differentials (IRDs) and high foreign exchange rate (FX) volatility have substantial explanatory power for the validity of UIP. We show that these contemporaneous drivers also have predictive power by implementing a conditional currency carry trade (CT) strategy that excludes regimes for which UIP is likely to hold. Conditioning high FX volatility only, or on both FX volatility and extreme IRDs outperforms the base-case unconditional CT strategy in virtually any of the settings analyzed. Conditioning on very large IRDs only shows mixed findings. Our strategy works best for smaller CT portfolios.