Temporal causality in purchasing power parity relationship: Evidence from Australia

Abstract

Studies to date have not yet been able to resolve the issue of the purchasing power parity (PPP) relationship in Australia. There have been mixed results regarding the validity of the PPP relationship. Moreover, the causality issue between exchange rate and relative prices has not been investigated in previous studies in the context of Australia. Using quarterly data from 1984:Q1 to 012:Q4, this paper examines three issues: (i) the co-integration between the exchange rate and elative prices, (ii) causality between the exchange rate and relative prices, and (iii) the time-varying property of the co-integrating vector. A log of the nominal exchange rate between Australia and the United States (AUD/USD) and a log of the ratio of the consumer price indices (CPIs) of the two countries were found to be co-integrated in the long run, which supports long-run PPP. Causality tests indicate that there is a causal effect of relative prices on the exchange rate in the long run. A time-varying co-integration analysis indicates that the co-integrating vector is not time-invariant and that the source of this invariant nature of the co-integrating vector seems to come from the coefficients of relative prices. The policy implication of these findings is that no policy intervention is needed to maintain the sustainability of external balance