Pairwise Tests of Purchasing Power Parity Using Aggregate and Disaggregate Price Measures

21 Pages Posted: 11 May 2006

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics

Ron Smith

Birkbeck College

Takashi Yamagata

University of Cambridge - Faculty of Economics and Politics

Liudmyla Hvozdyk

Ludwig Maximilian University of Munich (LMU) - Munich Graduate School of Economics (MGSE)

Date Written: April 2006

Abstract

In this paper we adopt a new approach to testing for purchasing power parity, PPP, that is robust to base country effects, cross-section dependence, and aggregation. Given data on N + 1 countries, i, j = 0, 1, 2, ..., N, the standard procedure is to apply unit root or stationarity tests to N relative prices against a base country, 0, e.g. the US. The evidence is that such tests are sensitive to the choice of base country. In addition, the analysis is subject to a high degree of cross section dependence which is difficult to deal with particularly when N is large. In this paper we test for PPP applying a pairwise approach to the disaggregated data set recently analysed by Imbs, Mumtaz, Ravan and Rey (2005, QJE). We consider a variety of tests applied to all possible N(N + 1)/2 pairs of real exchange rate pairs between the N + 1 countries and estimate the proportion of the pairs that are stationary, for the aggregates and each of the 19 commodity groups. This approach is invariant to base country effects and the proportion that are non-stationary can be consistently estimated even if there is cross-sectional dependence. To deal with small sample problems and residual cross section dependence, we use a factor augmented sieve bootstrap approach and present bootstrap pairwise estimates of the proportions that are stationary. The bootstrapped rejection frequencies at 26%-49% based on unit root tests suggest some evidence in favour of the PPP in the case of the disaggregate data as compared to 6%-14% based on aggregate price series.

Keywords: purchasing power parity, panel data, pairwise approach, cross section dependence

JEL Classification: C23, F31, F41

Suggested Citation

Pesaran, M. Hashem and Smith, Ron P. and Yamagata, Takashi and Hvozdyk, Liudmyla, Pairwise Tests of Purchasing Power Parity Using Aggregate and Disaggregate Price Measures (April 2006). CESifo Working Paper Series No. 1704, Available at SSRN: https://ssrn.com/abstract=901727

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics ( email )

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Ron P. Smith

Birkbeck College ( email )

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United Kingdom
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+44 207 631 6416 (Fax)

Takashi Yamagata

University of Cambridge - Faculty of Economics and Politics ( email )

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Cambridge, CB3 9DD
United Kingdom

Liudmyla Hvozdyk

Ludwig Maximilian University of Munich (LMU) - Munich Graduate School of Economics (MGSE) ( email )

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M√ľnchen, 80539
Germany

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