Mexico's futile attempt to defy purchasing power parity

Abstract

Many empirical studies have suggested that purchasing power parity (PPP) does not hold in the short run, and some conclude that PPP is not observed even in the long run. The recent collapse of the Mexican peso suggests otherwise, however. This study examines whether PPP has bound the nominal peso/dollar exchange rate and the Mexican and US price levels between 1920 and 1994. Given the long sample period,unit root tests were conducted taking structural breaks into account, but the variables were still found to contain unit roots. Cointegration tests confirm a relationship between the exchange rate and price levels, and an error correction model verifies that it has indeed been the PPP relationship that linked the variables. Deviations from PPP were corrected, on average, within four years. The confirmation of PPP during the period 1920–94 underscores the futility of Mexican policies that defied PPP in the early 1990s, after trade and capital flows were liberalized.