Purchasing power parity as a long‐run relation

TLDR

Purchasing power parity (PPP) is tested as a long‑run proposition using Dickey–Fuller and Stock–Watson tests within Granger’s cointegration framework, while recognizing that differing country price‑index weights relax the traditional unity‑coefficient constraint. The study applies Dickey–Fuller and Stock–Watson tests to assess PPP within a cointegration framework. The tests reject a general PPP relation, find evidence for PPP in only five of fifteen country pairs, and show that even when present it does not predict future nominal exchange rates, supporting efficient market theory.

Abstract

Abstract Dickey–Fuller and Stock–Watson tests of purchasing power parity (PPP) as a long‐run proposition are provided within the cointegration framework proposed by Granger. Since different countries use different weights to construct price indices, the traditional constraint that the coefficients on the price indices should be unity in the log‐linear PPP relation is relaxed. The absence of a general PPP relation cannot be rejected. At most, a PPP relation is indicated in five out of fifteen country pairs that are examined. Even if a long‐run PPP relation exists, it is not found to be useful in predicting future nominal exchange rates, which is consistent with efficient speculative markets.