Purchasing power parity doctrine: weak and strong form tests

Abstract

The purchasing power parity hypothesis is investigated within a highly economically integrated set of nations, namely the European Monetary System (EMS). The modern Phillips-Hansen Fully Modified Ordinary Least Squares (FM-OLS) procedure is used, which for the first time allows for an unrestricted cointegration test of the PPP doctrine. It corrects for both endogeneity in the data and asymptotic bias in the coefficient estimates. The entire floating exchange rate period is studied. The weak form (necessary condition) and strong form (necessary and sufficient condition) of PPP are sequentially tested for. The Phillips-Ouliaris non-stationarity test on the exchange rate-price ratio series residuals and the FM-WALD test for the required parameter values are conducted. Across the board evidence is found supporting co-integration between exchange rate and prices, i.e. the necessary condition (weak form PPP) is satisfied, with the sole exception of the Belgian Franc. But the necessary and sufficient condition (strong form PPP) is not supported for any of the currencies.