Academic journal article Journal of Economics and Finance

Investigating the PPP Hypothesis Using Constructed U.S. Dollar Equilibrium Exchange Rate Misalignments over the Post-Bretton Woods Period

Academic journal article Journal of Economics and Finance

Investigating the PPP Hypothesis Using Constructed U.S. Dollar Equilibrium Exchange Rate Misalignments over the Post-Bretton Woods Period

Article excerpt

(ProQuest: ... denotes formulae omitted.)

1 Introduction

The collapse of the Bretton Woods system in 1973, which lead to the floating of foreign exchange rates, has resuscitated, inter alia, the search for the appropriate fundamental model of exchange rate determination. The concept of a fundamental model, of necessity, implies the existence of equilibrium and the idea of equilibrium intrinsically implies the possibility of disequilibrium. Furthermore, the extent to which exchange rates are misaligned, or in disequilibrium, may be of critical importance to both policy makers and business executives.

A general definition of exchange rate misalignments is the deviation of the exchange rate from its equilibrium. While a broad consensus exists on how to define exchange rate deviations, there seems to be less agreement on how to construct a proper equilibrium exchange rate (EER). The difficulty in estimating the equilibrium is that the true EER, as such, is never observable. Consequently, the literature generally evaluates the appropriateness of any EER by the reverting behavior of the actual spot exchange rate towards the constructed equilibrium and/or the ability of the EER to predict the future path of the actual spot exchange rate. When constructing EERs many economists rely on relative purchasing power parity (PPP), which generally means the construction of the real exchange rate.1

The literature puts forward different methods to analyze the PPP hypothesis. One strand of studies tests if the real exchange rate is stationary (e.g. Meese and Rogoff1988; Mark 1990; Xu 2003; and Narayan 2005, 2006). Other methodologies are the Engle and Granger (1987) cointegration test (see for example Karfakis and Moschos 1989; Kim 1990; Patel 1990; Bleaney 1991) or the Johansen (1991) cointegration test (see for example Cheung and Lai 1993; Salehizadeh and Taylor 1999). The empirical evidence provided from those studies suggests that PPP holds in the very long-run, while there is little evidence to support PPP in the short-run, and particularly fails to hold during the current, rather short, period of floating exchange rates (e.g. Breuer 1994; MacDonald 1995; Froot and Rogoff1995; Rogoff1996; Lothian and Taylor 1996; Taylor 2002; and Taylor and Taylor 2004). The literature suggests that tests fail to reject the null hypothesis of a unit root or no-cointegration due to the low power of the tests as well as the short-time period after the Bretton Woods system (Frankel 1990; Froot and Rogoff1995; Lothian and Taylor 1997; Taylor and Taylor 2004).

Based on the above findings, researchers have applied panel data in an effort to mitigate the low power of the tests, with mixed results. For example, Frankel and Rose (1996), Jorion and Sweeney (1996), MacDonald (1996), Oh (1996), and Kalyoncu and Kalyoncu (2008) find stronger evidence in favor of PPP. The stronger support, however, seems to vanish if one controls for serial correlation Papell (1997) and Papell and Theodoridis (1998), or contemporaneous correlation O'Connell (1998) in the panel data estimation. Moreover, Taylor and Sarno (1998) and Karlsson and Lothgren (2000) emphasize that studies using heterogeneous panel data containing one stationary series and otherwise nonstationary series are more inclined to find evidence in favor of PPP.

Perron (1989) and Perron and Vogelsang (1992) demonstrate the importance of incorporating structural breaks when testing the unit root hypothesis. Yet, studies that account for structural breaks in univariate time series of the real exchange rate are only able to reject to null of a unit root for some currencies (e.g. Serletis and Zimonopoulos 1997; Narayan 2005). Others have combined the two strands of literature presented above by applying panel unit root tests with structural breaks and find strong evidence in favor of PPP (e.g. Papell 2002 and Narayan 2006).

More current papers find evidence that the real exchange rate follows a non-linear mean reverting behavior (e. …

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