A panel unit root test approach to PPP exchange rates with non-linear deterministic trends
Date
2005-10-14
Authors
Journal Title
Journal ISSN
Volume Title
Publisher
ORCID
Type
Degree Level
Masters
Abstract
This paper investigates the purchasing power parity (PPP) hypothesis
using panel data. Under PPP the real exchange rate is stationary around a
constant mean. Recent panel data unit root tests are employed to test the
PPP proposition where, under the conventional null hypothesis of a unit root,
the real exchange rate is not stationary and PPP does not hold. In this case,
as the time period t + n approaches infinity, its variance relative to period t will
also approach infinity. The usual alternative in unit root tests is stationarity
around a constant mean or a linear trend. The paper brings innovation into
the PPP and panel unit root testing literature by allowing for possible nonlinear
deterministic trends in the alternative hypothesis (as advanced by
Cushman (2004)). If the null hypothesis is rejected in favour of the alternative
of a non-linear trend, PPP still does not hold, but does at least revert back to
a meaningful, stable long-run equilibrium. Given this non-linear trend, the
variance of the real exchange rate as t + n approaches infinity, conditional on
that trend, remains finite.
Overall, evidence for stationarity in exchange rates is found in four out
of six panels under consideration, including both support for stationary
processes with no trend or a linear trend as well as for processes following a
non-linear deterministic trend, in particular at time orders 5 and 6. The
rejections are, in fact, most consistent at the nonlinear orders. Given
nonlinear trends, PPP as usually defined does not hold, despite the rejection
of unit roots. It is also found that stronger evidence for stable long-run
equilibria in real exchange rates appears when the German Deutschmark is
chosen as a base currency instead of the US Dollar. Finally, it appears that a
very recent panel unit root test that takes account of cross-sectional
dependencies delivers more consistent and sensible results.
Description
Keywords
non-linear deterministic trends, panel unit root testing, PPP
Citation
Degree
Master of Arts (M.A.)
Department
Economics
Program
Economics