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Purchasing power parity vs. uncovered interest rate parity for NAFTA countries: The value of incorporating time-varying parameter model

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  • Yoon, Jong Cheol
  • Min, Dai Hong
  • Jei, Sang Young

Abstract

In 1994, the United States, Canada, and Mexico signed the North American Free Trade Agreement (NAFTA) to strengthen economic cooperation. To examine the effects of the NAFTA, this study revisits Purchasing Power Parity (PPP) for NAFTA countries by applying a time-varying cointegration model. Under the time-varying assumption, it improves the explanatory power of reality via the model specification test. Given that, the validity of PPP for NAFTA countries varies over time. Especially, the PPP elasticity based on the consumer price index (CPI) is more volatile than the producer price index (PPI) -based. Thus, the stabilization policy of the consumption sector must be a high priority over the production sector. Moreover, the validity of the Uncovered Interest Rate Parity (UIRP) is examined by the time-varying cointegration model. The aim is to compare the results of the PPP and UIRP. This suggests that the PPP is more useful than the UIRP in evaluating the movement of the exchange rate in the long-run.

Suggested Citation

  • Yoon, Jong Cheol & Min, Dai Hong & Jei, Sang Young, 2020. "Purchasing power parity vs. uncovered interest rate parity for NAFTA countries: The value of incorporating time-varying parameter model," Economic Modelling, Elsevier, vol. 90(C), pages 494-500.
    • Handle: RePEc:eee:ecmode:v:90:y:2020:i:c:p:494-500
    DOI: 10.1016/j.econmod.2019.11.034
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    3. Bonga-Bonga, Lumengo, 2023. "Do trade frictions distort the purchasing power parity (PPP) hypothesis? A closer look," MPRA Paper 119196, University Library of Munich, Germany.

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    More about this item

    Keywords

    Purchasing power parity; Exchange rate determination; A time-varying cointegration model; A time-invariant cointegration model;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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