How Long is the Long Run? Evidence from the Foreign Exchange Market

Kenneth Clements and Yihui Lan ()
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Yihui Lan: Department of Economics, The University of Western Australia

No 05-03, Economics Discussion / Working Papers from The University of Western Australia, Department of Economics

Abstract: The aim of this paper is to estimate the length of the long run in the foreign exchange market. We do this by examining the link between exchange rates and relative prices, based on the implications of purchasing power parity (PPP) theory. Using a new approach, we test if the ratios of variances of exchange rates to prices are unity over all horizons, as implied by PPP. Through Monte Carlo simulations, we derive the variance ratios under the null of equal variances and examine the power and size of the test. We find evidence that PPP holds in the long run. While the long run based on the consumer prices appears to be “long”, about five years, the estimate of the long run based on the single good, Big Macs, is shorter (two years).

Pages: 15 pages
Date: 2005
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Citations: View citations in EconPapers (2)

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