Testing for PPP: Should We Use Panel Methods?

IGIER Working Paper No. 186

33 Pages Posted: 6 Apr 2001

See all articles by Anindya Banerjee

Anindya Banerjee

European University Institute - Department of Economics; University of Oxford - Department of Economics

Massimiliano Giuseppe Marcellino

European University Institute; European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS); Bocconi University - Department of Economics; Centre for Economic Policy Research (CEPR)

Chiara Osbat

European Central Bank (ECB)

Date Written: January 2001

Abstract

A common finding in the empirical literature on the validity of purchasing power parity (PPP) is that it holds when tested for in panel data, but not in univariate (i.e. country specific) analysis. The usual explanation for this mismatch is that panel tests for unit roots and cointegration are more powerful than their univariate counterparts. In this paper we suggest an alternative explanation for the mismatch. More generally, we warn against the use of panel methods for testing for unit roots in macroeconomic time series. Existing panel methods assume that cross-unit cointegrating or long-run relationships, that tie the units of the panel together, are not present. However, using empirical examples on PPP for a panel of OECD countries, we show that this assumption is very likely to be violated. Simulations of the properties of panel unit root tests in the presence of long-run cross-unit relationships are then presented to demonstrate the serious cost of assuming away such relationships. The empirical size of the tests is substantially higher than the nominal level, so that the null hypothesis of a unit root is rejected very often, even if correct.

Keywords: PPP, unit root, panel, cointegration, cross-unit dependence

JEL Classification: C23, C33, F31

Suggested Citation

Banerjee, Anindya and Marcellino, Massimiliano and Osbat, Chiara, Testing for PPP: Should We Use Panel Methods? (January 2001). IGIER Working Paper No. 186, Available at SSRN: https://ssrn.com/abstract=265899 or http://dx.doi.org/10.2139/ssrn.265899

Anindya Banerjee

European University Institute - Department of Economics ( email )

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Massimiliano Marcellino (Contact Author)

European University Institute ( email )

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European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

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Bocconi University - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR) ( email )

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Chiara Osbat

European Central Bank (ECB) ( email )

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Germany
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