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Unpuzzling the Purchasing Power Parity Puzzle

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  • Matteo Pelagatti
  • Emilio Colombo

Abstract

The empirical validation of the purchasing power parity (PPP) theory is generally based on real exchange rates built using consumer price indexes (CPI). The empirical evidence does not generally support the theory and this fact goes under the name of purchasing power parity puzzle. In this paper we show by theoretical arguments that, even if the law of one price holds for all the goods traded in two countries, real exchange rates based on CPI are not mean-reverting and therefore statistical tests based on them should reject the PPP hypothesis. We prove that such real exchange rates are neither stationary nor integrated, and so both unit-root and stationarity tests should reject the null according to their power properties. The performance of the most common unit-root and stationarity tests in situations in which the law of one price holds is studied by means of a simulation experiment, based on real European CPI weights and price behaviours.

Suggested Citation

  • Matteo Pelagatti & Emilio Colombo, 2012. "Unpuzzling the Purchasing Power Parity Puzzle," Working Papers 221, University of Milano-Bicocca, Department of Economics, revised Mar 2012.
    • Handle: RePEc:mib:wpaper:221
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    References listed on IDEAS

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    More about this item

    Keywords

    Purchasing power parity; Law of one price; Stationarity; Unit root.;
    All these keywords.

    JEL classification:

    • C30 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - General
    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes

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