Financial globalization and purchasing power parity in the G7 countries

Abstract

Financial globalization has huge opportunities and risks as it transforms supply and demand conditions in various countries. Competent macroeconomic management is needed to address the growing links between national economies and global financial markets. Johansen's cointegration technique was utilized with annual data on exchange rates and four price deflators (e.g. consumer price index, Wholesale Price Index (WPI), food price index and producer price index for manufacturing) to investigate the validity of long-run purchasing power parity in the G7 countries during the 1951 to 2006 period. We found support for purchasing power parity, thereby making it a useful guide for exchange rate policy reforms. Depending on the price index used, adjustment to exchange rate and price shocks take 0.35–8.20 years to return to equilibrium levels.

Acknowledgement

We thank Dr. Nomathemba Seme for comments and suggestions on earlier versions of the article.

Notes

The views expressed in this article do not reflect the official position of Ameriprise Financial Services or its affiliates. The author accepts full responsibility for any errors or omissions.

¹The error-correction model based on the PPP relation is specified as

where EC _t−1 is the lagged residual (error-correction term) from the cointegration regression, ε _t is the stochastic disturbance term, α₀ is a constant, β₁, β₂ and β₃ are parameters representing elasticities, k is the length of the lag, γ is the speed of adjustment and Δ is the first difference operator.