Revisiting purchasing power parity for G-7 countries using nonparametric rank test for cointegration

Abstract

This study applies the nonparametric rank test for cointegration, proposed by Breitung (2001), to test the validity of long-run Purchasing Power Parity (PPP) for G-7 countries over the period of January 1980 to January 2009. The empirical results indicate that PPP holds true for all G-7 countries studied and that the nominal exchange rate and the domestic and US Consumer Price Index (CPI) are nonlinearly interrelated with the exception of France and Germany cases. Our results have important policy implications for the G-7 countries under study.

Keywords:

• nonparametric rank test for cointegration
• purchasing power parity
• G-7 countries

JEL Classification:

• C22
• F31

Acknowledgements

The authors are grateful to Professors Haug and Basher for providing the GAUSSS program codes. Finally, we thank an anonymous referee and the co-editor (Professor David Peel) of this journal for their several helpful comments, suggestions and time spent in reading this article. These all make this article more valuable and readable.

Any errors that remain are our own.

Notes

¹According to Holmes (2001), the Purchasing Power Parity (PPP) is important to policymakers for two reasons. First of all, it can be used to predict exchange rate to determine whether a currency is over- or undervalued. Whether a currency is over- or undervalued is particularly important for less developed countries and also for those experiencing large differences between domestic and foreign inflation rates. Second, the notion of PPP is used as the foundation on which many theories of exchange rate determination are built. Consequently, the validity is important to those policymakers in developing countries who base their adjustment on the PPP. Other reasons about the policy implications of PPP, see Taylor and Taylor (2004).

²Simulated critical values of B ₁, B ₂, , and are given in table 1 of Breitung (2001).

Table 1. Results of nonparametric rank tests for cointegration

³Kapetanios et al. (2003) also proposed a testing procedure to detect the presence of nonstationarity against nonlinear but globally stationary Exponential Smooth Transition AutoRegressive (ESTAR) process. They constructed t-statistic of test by regressing the following auxiliary equation based on Taylor series using ordinary least squares:

In this framework, the null hypothesis and alternative hypothesis are expressed as δ = 0 (nonstationary) against δ < 0 (nonlinear ESTAR stationary). Following the suggestion of an anonymous referee, we also add the Kapetanios et al.’s (2003) test in our study. The results are similar to those found from the ADF and PP tests (not reported here but are available upon request).

⁴Juvenal and Taylor (2008) and Kilian and Taylor (2003) suggested that nonlinearity may arise from the heterogeneity of opinion in the foreign exchange market concerning the equilibrium level of the nominal exchange rate: as the nominal rate takes on more extreme values, a great degree of consensus develops concerning the appropriate direction of exchange rate moves, and traders act accordingly.