A simple test for PPP among traded goods

Abstract

The so-called Balassa-Samuelson model implies that relative prices ofnon-traded goods may be nonstationary and, hence, that PPP should preferably betested on real exchange rates based on prices of traded goods only. We proposea simple test for PPP among traded goods which can be applied to real exchangerates based on prices of all (that is, both traded and non-traded) goods. Weshow through simulations that the test is reliable for a sample size commonlyconsidered in practice. Upon applying the test to bilateral real exchange ratesbased on the general CPI among a group of industrialized countries during therecent float, we find little evidence in favor of PPP among traded goods. Thisdoes not change when we use real exchange rates based on various componentsof the CPI.Purchasing power parity;Unidentified nuisance parameters;Unit roots