Testing Long-Run PPP in the Presence of Sticky Prices

32 Pages Posted: 23 Oct 2000

See all articles by Gikas A. Hardouvelis

Gikas A. Hardouvelis

University of Piraeus; Centre for Economic Policy Research (CEPR)

Dimitrios Malliaropulos

University of Piraeus - Department of Banking and Financial Management; National Bank of Greece

Abstract

In this paper we show that standard tests for long-run Purchasing Power Parity (PPP) are misspecified if aggregate prices are sticky. Using Monte Carlo simulations, we show that in small samples the ADF test has low power to reject the null of no cointegration when long-run PPP is tested using current prices instead of long-run equilibrium prices. We propose an alternative two-step testing procedure, which consists of, first, estimating long-run equilibrium prices from a standard money demand function and, then, testing long-run PPP as a relationship between the current exchange rate and long-run \QTR{em}{equilibrium} price differentials. Finally, we show that in small samples our proposed test has considerably higher power than the standard ADF test for a unit root in the real exchange rate. We apply our test to the effective exchange rate of the Greek drachma in the post-Bretton Woods period and find that it is closely linked to long-run equilibrium price differentials.

Keywords: PPP, unit roots

JEL Classification: F31, E41

Suggested Citation

Hardouvelis, Gikas A. and Malliaropulos, Dimitrios, Testing Long-Run PPP in the Presence of Sticky Prices. Available at SSRN: https://ssrn.com/abstract=233655 or http://dx.doi.org/10.2139/ssrn.233655

Gikas A. Hardouvelis

University of Piraeus ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece
+32010 4142323 (Phone)
+3210 6724848 (Fax)

HOME PAGE: http://www.eurobank.gr

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Dimitrios Malliaropulos (Contact Author)

University of Piraeus - Department of Banking and Financial Management ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece
(+30) 210 3341527 (Phone)
(+30) 210 3341702 (Fax)

National Bank of Greece ( email )

86 Eolou Str.
10232 Athens
Greece
+30 1 3251133 (Fax)

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