Purchasing Power Parity and Heterogenous Mean Reversion

Kees Koedijk, Ben Tims and Mathijs van Dijk ()

No 5473, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper analyses the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. This can have a dramatic impact on inferences made on the validity of the PPP hypothesis. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

Keywords: International economics; Purchasing power parity; Real exchange rates; Panel models; Unit root tests; Heterogeneity (search for similar items in EconPapers)
JEL-codes: F31 F33 G15 (search for similar items in EconPapers)
Date: 2006-01
New Economics Papers: this item is included in nep-fin, nep-fmk and nep-ifn
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Working Paper: Purchasing Power Parity and Heterogeneous Mean Reversion (2005)
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