A possible solution for the purchasing power parity puzzle: panel cointegration

Szabó, Andrea (2018) A possible solution for the purchasing power parity puzzle: panel cointegration. Hungarian Statistical Review, 1 (1). pp. 70-90. ISSN 2630-9130

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Abstract

PPP (purchasing power parity) explaining the longrun behaviour of nominal exchange rates is one of the most fundamental theories in international economics. However, its empirical validity is controversial and thus, referred to as the PPP puzzle in the literature (Rogoff [1996]). While many possible improvements of the baseline model have been suggested, the importance of the appropriate empirical methodology in testing PPP has been given less attention. Since PPP describes a longrun equilibrium relationship, the proper testing method involves testing for cointegration. As the efficiency of panel estimations is greater because of the higher number of observations, this study investigates the empirical validity of PPP with three cointegrated panel estimation methods, with the DFE (dynamic fixed-effects), the MG (mean-group), and the PMG (pooled mean-group) estimations. PPP is confirmed in all three samples using the DFE estimator. The results most accurately matching the theoretical expectations are found in the 1985–2011 sample.

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