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On the Empirical Failure of Purchasing Power Parity Tests
Author(s) -
Pelagatti Matteo,
Colombo Emilio
Publication year - 2014
Publication title -
journal of applied econometrics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 2.878
H-Index - 99
eISSN - 1099-1255
pISSN - 0883-7252
DOI - 10.1002/jae.2418
Subject(s) - purchasing power parity , unit root , econometrics , economics , price index , null hypothesis , mean reversion , empirical research , law of one price , exchange rate , relative purchasing power parity , unit root test , financial economics , statistics , monetary economics , price level , mathematics , mid price , cointegration
Summary Empirical research on the validity of the purchasing power parity (PPP) condition is generally based on real exchange rates built using the consumer price index (CPI), but fails to provide clear support to PPP. In this paper we show theoretically that, even if the law of one price (LOP) holds for traded goods, CPI‐based real exchange rates are not mean reverting, and are neither stationary nor integrated. Therefore, both unit root and stationarity tests should reject their null. Our theoretical results are validated both by simulations and an empirical application. Copyright © 2014 John Wiley & Sons, Ltd.