DP5473 Purchasing Power Parity and Heterogenous Mean Reversion

Author(s): Kees Koedijk , Ben Tims , Mathijs A Van Dijk

Publication Date: January 2006

Keyword(s): international economics , Purchasing power parity , real exchange rates , panel models , unit root tests , heterogeneity

JEL(s): F31 , F33 , G15

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5473.asp

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.