PPP and the Real Exchange Rate - Real Interest Rate Differential Puzzle Revisited: Evidence from Non-Stationary Panel Data

Bank of England Working Paper No. 138

30 Pages Posted: 24 Jul 2001  

Georgios E. Chortareas

University of Athens - Faculty of Economics; University of Essex - Department of Accounting, Finance & Management; King's College London

Rebecca L. Driver

affiliation not provided to SSRN

Date Written: June 2001

Abstract

This paper examines the evidence for two of the relationships that underpin (explicitly or implicitly) much of international macroeconomics. The first is purchasing power parity (PPP), or the hypothesis that there exists a constant long-run equilibrium real exchange rate. The second establishes a relationship between real exchange rates and real interest rate differentials. The tests are conducted on a panel of 18 OECD economies using the United States as a numeraire for the post-Bretton Woods era. The results are obtained using new non-stationary panel estimation techniques, which significantly increase the power of the tests. All the tests suggest that there is little evidence supporting PPP when it is tested directly. This contrasts with earlier panel data studies, which tended to find that the real exchange rate was stationary. The results supporting a long-run relationship between real exchange rates and real interest rate differentials appear to be more positive. This again provides a contrast with earlier results, which tended to find no evidence of cointegration. Such studies concentrated on G7 economies. To investigate this further the panel was split into two groups: the G7 and eleven small open economies. For the panel of small open economies strong evidence in favour of cointegration is found. In contrast, there is no evidence of cointegration in a panel that consists purely of the G7 economies.

Keywords: PPP, real exchange rate-real interest rate differentials, non-stationary panels

JEL Classification: C23, F31

Suggested Citation

Chortareas, Georgios E. and Driver, Rebecca L., PPP and the Real Exchange Rate - Real Interest Rate Differential Puzzle Revisited: Evidence from Non-Stationary Panel Data (June 2001). Bank of England Working Paper No. 138. Available at SSRN: https://ssrn.com/abstract=274992 or http://dx.doi.org/10.2139/ssrn.274992

Georgios Chortareas (Contact Author)

University of Athens - Faculty of Economics ( email )

8 Pesmazoglou street
GR-10559 Athens
Greece
+(30) 210 3689805 (Phone)
+(30) 210 3689810 (Fax)

University of Essex - Department of Accounting, Finance & Management ( email )

Wivenhoe Park
Colchester CO4 3SQ
United Kingdom

King's College London ( email )

Strand
London, England WC2R 2LS
United Kingdom

Rebecca L. Driver

affiliation not provided to SSRN

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