Testing nonlinearities in purchasing power parity

Abstract

This note presents some empirical evidence on the presence of nonlinear adjustment in the PPP relationship. Nonlinearities are shown to be captured by a polynomial in the error correction term. It is also shown that there is some evidence for PPP when the hypothesis is tested over the period of the recent floating using the Yen/DM exchange rate. Using the residual of the cointegrating regression as an error correction term, two error correction models are estimated, and non-nested model selection testing reveals that nonlinear adjustment is predominant.