Purchasing Power Parity and Heterogenous Mean Reversion

42 Pages Posted: 8 May 2006

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: January 2006

Abstract

This paper analyses the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology 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. This can have a dramatic impact on inferences made on the validity of the PPP hypothesis. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.

Keywords: International economics, purchasing power parity, real exchange rates, panel models, unit root tests, heterogeneity

JEL Classification: F31, F33, G15

Suggested Citation

Koedijk, Kees G. and Tims, Ben and Van Dijk, Mathijs A., Purchasing Power Parity and Heterogenous Mean Reversion (January 2006). CEPR Discussion Paper No. 5473. Available at SSRN: https://ssrn.com/abstract=901232

Kees G. Koedijk (Contact Author)

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

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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