Working Paper: CEPR ID: DP5473
Authors: Kees Koedijk; Ben Tims; Mathijs A. van Dijk
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: heterogeneity; international economics; panel models; purchasing power parity; real exchange rates; unit root tests
JEL Codes: F31; F33; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| homogeneous estimation of mean reversion parameters (C51) | serious biases in the estimates (C51) |
| homogeneous mean reversion assumption violated (C22) | serious biases in estimates (C51) |
| homogeneous estimation (C51) | low statistical power (C46) |
| homogeneous estimation (C51) | non-monotonic power functions (C29) |
| allowing for heterogeneous estimation and testing (C51) | improves accuracy of inferences regarding PPP hypothesis (F31) |