Testing the purchasing power parity through I(2) cointegration techniques

Abstract

SUMMARYThis paper contributes to the empirical literature on the purchasing power parity (PPP) over the post-Bretton Woods period by providing a time-series based interpretation of the controversial evidence characterizing the dynamics of real exchange rates. It is shown that the persistence of deviations from the PPP between a set of European countries and the United States may be empirically attributed to the presence of I(2) stochastic trends in prices using Consumer Price Indices. Interestingly, the slow adjustment towards the equilibrium can be modelled through 'integral-proportional' equilibrium correction models and this evidence can be partly reconciled with theories where the inflation rate reduces the markup of profit-maximizing firms acting on imperfectly competitive markets.

International dynamic risk sharing

“…Second, as agents are forward-looking in an environment characterized by impediments to trade and factor (especially labour) mobility, beliefs on the evolution of expected future consumption changes of the leader country and of real exchange rates of all countries affect the risk sharing allocation. Third, consistently with recent findings (see Bacchiocchi and Fanelli, 2005, and references therein), our model do not require that PPP holds among the countries in the risk sharing pool; this feature contrasts with the large majority of papers on international risk sharing tests where PPP is assumed to hold and the FRS proposition tends to be rejected. As a result, correcting the tests of the FRS hypothesis for the dynamics implied by costs of adjustment and expectations on future market developments helps to explain why according to traditional analyseswhere a dynamic structure is omitted -international risks are poorly shared.…”

Speed of adjustment in cointegrated systems

“…These results are not incompatible with Bacchiocchi and Fanelli (2005), who …nd an I(2) stochastic trend for the GE/US pair over the longer period 1973. 04-1998.02.…”

A Resolution of the Purchasing Power Parity Puzzle: Imperfect Knowledge and Long Swings

“…This pattern is clearly evident in …gure 1, which shows that the German mark-US dollar exchange rate moves away from purchasing power parity (PPP) for extended periods but eventually, at unpredictable moments of time, undergoes sustained movements back toward parity. 1 Most estimates of the half-life of PPP deviations-the number of years that a PPP deviation is expected to decay by 50 percent-are in the range of 3-5 years. Thus, while PPP deviations are ultimately bounded, they are highly persistent.…”

“…These conclusions are consistent with several other studies that …nd I(2) trends in time-series data on, for example, exchange rates, goods prices, and money supplies. See, Johansen (1992), Juselius (1994), Kongsted (2003Kongsted ( , 2005, Kongsted and Nielsen (2004), and Bacchiocchi and Fanelli (2005 to PPP; individuals invariably predict a tendency of the exchange rate to revert back to this benchmark. Consequently, the exchange rate tends to revert back to PPP following a jump, in say, the money supply.…”