Is the real effective exchange rate biased against the PPP hypothesis?

Ventosa-Santaulària, Daniel and Wallace, Frederick and Gómez-Zaldívar, Manuel (2012): Is the real effective exchange rate biased against the PPP hypothesis?

Abstract

We show that the use of the real effective exchange rate to test for purchasing power parity, as in Astorga (2012) and other studies, introduces a bias against finding evidence of PPP. The bias is illustrated using unit root tests applied to bilateral real rates.

• Item Type: MPRA Paper
• Language: English
• Keywords: PPP; real effective exchange rate; stationarity
• Subjects: C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C22 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes; F - International Economics > F3 - International Finance > F31 - Foreign Exchange

References

Andrews, D.W.K., 1993. Exactly median-unbiased estimation of first order autoregressive/unit root models, Econometrica 61, No 1 139–165.

Arize, A.C., 2011.Purchasing power parity in LDCs: An empirical investigation, Global Finance Journal 22, 56-71.

Astorga, P., 2012.Mean reversion in long-horizon real exchange rates: Evidence from Latin America, Journal of International Money and Finance 31, 1529–1550.

Bahmani-Oskooee, M., Hegerty S.W., and Kutan, A.M., 2009. Is PPP sensitive to time- varying trade weights in constructing real effective exchange rates? Quarterly Review of Economics and Finance 49, 1001-1008.

Bahmani-Oskooee, M.,Kutan, A.M., and Zhou S., 2008. Do real exchange rates follow a nonlinear mean reverting process in developing countries? Southern Economic Journal 74, 1049-1062.

Christiano, L., 1992.Searching for a break in GNP, Journal of Business & Economic Statistics 10, 237–250.

Dickey, D. Fuller, W., 1979.Distribution of the estimators for autoregressive time series with a unit root, Journal of the American Statistical Association 74, 427–431.

Engle, R.F. and Granger, C.W.J, 1987. Co-integration and error correction: representation, estimation, and testing, Econometrica 55 (2), 251-276.

Kapetanios, G., 2005. Unit-root testing against the alternative hypothesis of up to m structural breaks, Journal of Time Series Analysis 26 (1), 123-133.

Lumsdaine, R.L. and Papell, D.H., 1997. Multiple trend breaks and the unit-root hypothesis, Review of Economics and Statistics 79, 212-218.

Perron, P., 1989. The great crash, the oil price shock and the unit root hypothesis, Econometrica 57, 1361–1401.

____________ , 1990.Testing for a unit root in a time series with a changing mean, Journal of Business & Economic Statistics8, 153–162.

Sollis, R.,Leybourne, S. and Newbold, P., 2002. Tests for symmetric and asymmetric nonlinear mean reversion in real exchange rates, Journal of Money, Credit, and Banking 34, 686–700.

Taylor, A., 2002. A century of purchasing-power-parity, Review of Economics and Statistics 84, 139-150.

Zivot, E., and Andrews, D., 1992. Further evidence on the great crash, the oil-price shock, and the unit-root hypothesis, Journal of Business & Economic Statistics 10, 251–270.