Why Panel Tests of Purchasing Power Parity Should Allow for Heterogeneous Mean Reversion

43 Pages Posted: 12 Dec 2005 Last revised: 16 May 2011

See all articles by Kees C. G. Koedijk

Kees C. G. Koedijk

Tilburg University - Department of Finance

Ben Tims

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM)

Mathijs A. Van Dijk

Erasmus University - Rotterdam School of Management; Erasmus Research Institute of Management (ERIM)

Multiple version iconThere are 3 versions of this paper

Date Written: October 12, 2010

Abstract

Recent studies of purchasing power parity (PPP) use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates. In contrast to several other severe restrictions of panel models and tests of PPP, the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. This paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies. Using Monte Carlo simulation, we uncover important adverse properties of the panel approach 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. These properties can lead to misleading inferences on the validity of PPP. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

Keywords: PPP, real exchange rates, panel models, unit root tests, heterogeneity, panel tests

JEL Classification: F31, F33, F47

Suggested Citation

Koedijk, Kees G. and Tims, Ben and Van Dijk, Mathijs A., Why Panel Tests of Purchasing Power Parity Should Allow for Heterogeneous Mean Reversion (October 12, 2010). Journal of International Money and Finance, Vol. 30, pp. 246-267, 2010. Available at SSRN: https://ssrn.com/abstract=868548 or http://dx.doi.org/10.2139/ssrn.868548

Kees G. Koedijk

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 4663048 (Phone)
+31 13 4662052 (Fax)

Ben Tims

Erasmus University Rotterdam (EUR) - Rotterdam School of Management (RSM) ( email )

P.O. Box 1738
Room T08-21
3000 DR Rotterdam, 3000 DR
Netherlands

Mathijs A. Van Dijk (Contact Author)

Erasmus University - Rotterdam School of Management ( email )

P.O. Box 1738
Rotterdam, 3000 DR
Netherlands
+31 10 408 1124 (Phone)
+31 10 408 9017 (Fax)

HOME PAGE: http://mathijsavandijk.com/

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

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