Location of Repository

Pairwise tests of purchasing power parity

By M.H. Pesaran, Ron P. Smith, T. Yamagata and L. Hvozdyk


Given nominal exchange rates and price data on N + 1 countries indexed by i = 0,1,2,…, N, the standard procedure for testing purchasing power parity (PPP) is to apply unit root or stationarity tests to N real exchange rates all measured relative to a base country, 0, often taken to be the U.S. Such a procedure is sensitive to the choice of base country, ignores the information in all the other cross-rates and is subject to a high degree of cross-section dependence which has adverse effects on estimation and inference. In this article, we conduct a variety of unit root tests on all possible N(N + 1)/2 real rates between pairs of the N + 1 countries and estimate the proportion of the pairs that are stationary. This proportion can be consistently estimated even in the presence of cross-section dependence. We estimate this proportion using quarterly data on the real exchange rate for 50 countries over the period 1957-2001. The main substantive conclusion is that to reject the null of no adjustment to PPP requires sufficiently large disequilibria to move the real rate out of the band of inaction set by trade costs. In such cases, one can reject the null of no adjustment to PPP up to 90% of the time as compared to around 40% in the whole sample using a linear alternative and almost 60% using a nonlinear alternative

Topics: ems
Publisher: Taylor and Francis
Year: 2009
OAI identifier: oai:eprints.bbk.ac.uk.oai2:1989

Suggested articles



  1. A Pair-Wise Approach to Testing for Output and Growth Convergence”, doi
  2. A Simple Panel Unit Root Test in the Presence of Cross Section Dependence”, doi
  3. (1995). Alternative Estimators and Unit Root Tests for the Autoregressive Process”, doi
  4. (2007). An Empirical Analysis of Nonstationarity in Panels of Interest Rates with Factors”, doi
  5. Chue (2007), “Subsampling Hypothesis Tests for Nonstationary Panels with Applications to Exchange Rates and Stock Prices”, doi
  6. (1996). Efficient Tests for an Autoregressive Unit Root”, doi
  7. (2006). Estimation and Inference in Large Heterogeneous Panels with a Multifactor Error Structure”, doi
  8. (2006). Exchange Rate Puzzles: A Tale of Switching Attractors”, doi
  9. (2006). Global and National Macroeconometric Modelling: A Long-Run Structural Approach, doi
  10. (2006). Is the Iceberg Melting Less Quickly? International Trade Costs after World War II”, Warwick Economic Research Papers No.764, doi
  11. (2007). Long Run Macroeconomic Relations in the Global Economy”, economics - The Open-Access, Open-Assessment E-Journal, doi
  12. (2006). Pairwise Tests of Purchasing Power Parity Using Aggregate and Disaggregate Price Measures”, Cambridge Working Paper in Economics No. doi
  13. (2006). Panels with Nonstationary Multifactor Error Structures”, Cambridge Working Papers in Economics 0651, doi
  14. (2003). Testing for a Unit Root in a Nonlinear STAR Framework”, doi
  15. (2004). Testing for a Unit Root in Panels with Dynamic Factors”, doi
  16. (1992). Testing the Null Hypothesis of Stationarity Against the Alternative of a Unit Root”, doi
  17. (2005). Testing the Unit Root Hypothesis Against Three-Regime TAR Non-Linearity: An Investigation of STAR Based Tests”, mimeo, doi
  18. (2004). Tests for Unit-Root versus Threshold Specification With an Application to the Purchasing Power Parity Relationship”, doi
  19. (1998). The Overvaluation of Purchasing Power Parity”, doi
  20. (2004). The Purchasing Power Parity Debate”, doi
  21. (2004). Trade Costs”, doi
  22. (1997). Transactions Costs and Non Linear Adjustment in the Real Exchange Rate”, doi
  23. (2007). Unit Roots and Cointegration doi
  24. (2006). US Real Exchange Rate Fluctuations and Relative Price Fluctuations”, doi

To submit an update or takedown request for this paper, please submit an Update/Correction/Removal Request.