Purchasing Power Parity and Heterogeneous Mean Reversion

Kees Koedijk, Ben Tims and Mathijs van Dijk ()

ERIM Report Series Research in Management from Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam

Abstract: This paper analyzes 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: Heterogeneity; Panel Models; Purchasing Power Parity; Real Exchange Rates; Unit Root Tests (search for similar items in EconPapers)
JEL-codes: F31 F33 G15 G3 M (search for similar items in EconPapers)
Date: 2005-12-19
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Working Paper: Purchasing Power Parity and Heterogenous Mean Reversion (2006)
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