Purchasing Power Parity between the UK and the Euro Area
Open Economies Review, September 2014
53 Pages Posted: 1 Feb 2013 Last revised: 18 Mar 2015
Date Written: January 31, 2013
We use the Johansen cointegration approach to assess the empirical validity of the purchasing power parity (PPP) between the UK and the Euro Area, which we represent by Germany, the largest of its members. We conduct the empirical analysis in the context of the global financial crisis that began in 2007 and find that it directly affects the cointegration space. We fail to validate the Johansen and Juselius (1992) original hypothesis that nonstationarity of the PPP associates with the nonstationarity of interest rate differentials to produce a stationary relation. On the other hand, we do not reject PPP. We find that PPP cointegrates with inflation differentials. We also find, contrary to conventional wisdom, that (i) equilibrium adjustment occurs between the German and UK inflation rates, while weak exogeneity exists for the German and UK interest rates and the PPP condition, and (ii) three common trends associated with the German interest rate, the UK interest rate, and the PPP condition “push” the system with the German interest rate and the PPP condition playing dominant roles.
Keywords: Purchasing Power Parity, Euro Area, Cointegrated VAR
JEL Classification: E31, E43, F31, F32
Suggested Citation: Suggested Citation