Unpuzzling the Purchasing Power Parity Puzzle

Matteo Pelagatti and Emilio Colombo

No 221, Working Papers from University of Milano-Bicocca, Department of Economics

Abstract: The empirical validation of the purchasing power parity (PPP) theory is generally based on real exchange rates built using consumer price indexes (CPI). The empirical evidence does not generally support the theory and this fact goes under the name of purchasing power parity puzzle. In this paper we show by theoretical arguments that, even if the law of one price holds for all the goods traded in two countries, real exchange rates based on CPI are not mean-reverting and therefore statistical tests based on them should reject the PPP hypothesis. We prove that such real exchange rates are neither stationary nor integrated, and so both unit-root and stationarity tests should reject the null according to their power properties. The performance of the most common unit-root and stationarity tests in situations in which the law of one price holds is studied by means of a simulation experiment, based on real European CPI weights and price behaviours.

Keywords: Purchasing power parity; Law of one price; Stationarity; Unit root. (search for similar items in EconPapers)
JEL-codes: C22 C30 (search for similar items in EconPapers)
Pages: 19 pages
Date: 2012-03, Revised 2012-03
New Economics Papers: this item is included in nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:mib:wpaper:221

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