International Research Journal of Finance and Economics ISSN 1450-2887 Issue 70 (2011) EuroJournals Publishing, Inc. 2011 http://www.eurojournals.com/finance.

htm

Purchasing Power Parity as the Determinant of Exchange Rates: Evidence from the UK and India
Zakaria Karim School of Ecnomics and Finance, Queen Mary University of London E-mail: zakariakarim07@gmail.com Tel: +44 750 753 5941 Abstract The aim of the empirical work was to set up a test to check whether the Purchasing Power Parity (PPP) theory holds in the long run or not and also to compare the effect on PPP when using both long and short horizon data. Most of the previous researches have been concluded with mixed results. The objectives were to use the co-integration and unitroot test of the data of exchange rate and consumer price index from the UK and India. The data was collected from the database of Queen Mary University of London, School of Economics and Finance. The research indicates the evidence of purchasing power parity theory to hold in the long-run. Keywords: Purchasing Power Parity, Foreign Exchange Rate, Law of One Price, Random Walk, Co-integration, Unit Root

1. Introduction
The invention of Purchasing Power Parity (PPP) theory is a mile stone in international economics to establish exchange rates between considering countries although there is still controversies. This theory tells us that the same unit of money, in a common currency, should have the power to purchase same amount of identical good in both the comparing countries. Simply saying the price of the identical good should be same in comparing countries. A number of researches have been conducted to test the validity and the strength of this theory. Although the assumption of no arbitrage is almost impossible in the real world, many researchers have found supportive evidence of this theory between many countries. There are two versions of PPP; absolute PPP and relative PPP. Researchers have worked to find evidence for both long and short-run PPP and got mixed result that are sometimes conclusive sometimes not. This study intends to test the theory between the UK and India using the consumer price index and the nominal exchange rates. The idea here is the price and exchange rate moves together and change in price can quantify the amount of change in exchange rates. If this is true then PPP significantly determines the exchange rate. So, the aim of this research is to test the PPP theory as the determinant of exchange rates. The main specific objectives are; To investigate the long-run PPP between UK and India To investigate the short-run PPP between UK and India To compare between long and short-run PPP

International Research Journal of Finance and Economics - Issue 70 (2011)

130

The purchasing power parity theory formulated in the 16th century by the scholars of the Salamanca School in Spain (Officer, 2006) and has reinforced after the publication of Swedish economist Gustav Cassels empirical study in the 1922. Since then it is the most important and widely used economic theory to determine foreign currency exchange rates. The theory asserts that price of identical good between two countries must be equal when expressed in a common currency which refers to the idea of low of one price. The law of one price is the basic unit of purchasing power parity (Rogoff, 1996) while the long-run PPP is the fundamental building block of exchange rate (Abuaf & Jorion, 1990). According to the law of one price, identical goods or services should be traded for the same price in different countries if prices are expressed in a common currency and under assumptions of no arbitrage condition, simply saying no transportation cost and governmental trade barriers (e.g., tariffs). This can be expressed by the following equation; Pi = EPi* (1) Where Pi is the price of good (i) in domestic currency, Pi* is the price of the same good in foreign currency and E is the exchange rate expressed as domestic/foreign currency. The idea of law of one price is not applicable to non-identical commodities (Krugman & Obstfeld, 2009; pp.382-416). Under floating exchange rate it is very difficult to reject the random walk hypothesis for real exchange rates (Abuaf & Jorion, 1990 and Rogoff, 1996) which means in the long run there is no possibility for the PPP to hold. The same result was found by Adler and Lehmann (1983). However, others have supported the random walk hypothesis for nominal exchange rates. Later on, Frankel (1990) has blamed the lack of long horizon time series data as the reason why researchers fail to reject the random walk model of real exchange rates. In 1996, Rogoff proposed that most economists believe in some variant of PPP as an anchor of long run real exchange rates. Narayan (2006) considers policies as an important factor of PPP since policy makers holds control over exchange rates valuation. The long horizon dataset is recognized as the power of the test (for example Frankel, 1990) and is very essential to prove any evidence of PPP (Moosa, 1994). PPP is not evident under floating exchange rate condition (Abuaf & Jorion, 1990; Rogoff, 1996 and Serletis & Gogas, 2004). While others (Cheung & Lai, 1993; Pippenger, 1993 and Kugler & Lenz, 1993) have got evidence of PPP using high-frequency monthly data in floating rates. Rogoff (1996) argued that some recent researches have got evidence of PPP in the very long run. Purchasing power parity was the centre point of the determination and changes in exchange rates that have been offset sometimes but temporarily. Up to 1970s most of the researchers worked to find out the disturbances to purchasing power parity. One significant reason behind that was the lack of statistical tools to perform analyses to differentiate between long and short-run effects of PPP (Officer 1976). 2.1. Evidence of PPP: Co-integration and Stationarity Test The co-integration test was first used by Granger in 1983, and later on, Engle and Granger in 1987 gave it a more complete form (Layton and Stark, 1990). After that many researches had been conducted to test the PPP theory on the basis of the relation between PPP, price level and the exchange rate (Moosa, 1994). In the late 1980s and early 1990s a group of economists (Taylor, 1988; Karfakis and Moschos, 1989; Kim, 1990; Patel, 1990 and Bleaney, 1991), tested the co-integration between nominal exchange rate and price levels and the results were some positive and some negative. In the early 1990s few others (Mark, 1990; Grilli and Kaminsky, 1991 and Flynn and Boucher, 1993), studied PPP by testing the univariate unit root and they have also got mixed result. In the late 1990s and early 2000s another group of researchers (Frankel & Rose, 1996; Papell & Theodoridis, 1998; OConnell, 1998; Fleissig & Strauss, 2000; and Ho, 2002), engaged panel unit root techniques to test the stationarity of real exchange rates where only Ho, (2002) found evidence of PPP and others did not. The most recent studies (Taylor et al., 2001; Chortareas et al., 2002; Kilian & Taylor, 2003; Chortareas & Kapetanios, 2003 and Sarno et al., 2004) tested stationarity of real exchange rates applying

2. Synthesis of Literature

131

International Research Journal of Finance and Economics - Issue 70 (2011)

nonlinear unit root techniques where Taylor et al., (2001), Chortareas & Kapetanios, (2003) and Sarno et al., (2004) found evidence of stationarity in favour of PPP. 2.2. Deviations from PPP Transportation Costs - No transportation Costs is the main assumption of low of one price and PPP which is not possible in the real world (Pakko and Pollard, 2003). Tariffs and Taxes - The theory of Cassel (1918) stated that, If trade between two countries is more hampered in one direction than in the other, the value of the money whose export is relatively more restricted will, fall in the other country, beneath the purchasing power parity (Cassel, 1918). Non-tradable Goods - The costs non-tradable goods have a greater impact on deviation from PPP because of its correspondence with the productivity of a country. Different Price Indices - As PPP theory has been generated from the law of one price, the appropriate price index should be related to the traded goods. Bleaney (1992), for example, has used the wholesale price index instead of the consumer price index because the consumer price index includes a significant component of non-tradable goods which deviates PPP. That is why Officer, (1976) was reluctant to use the wholesale price index, because it biases results in favour of PPP and this is the case why researches (Kim, 1990; MacDonald, 1988; McNown and Wallace, 1989) using wholesale price found results supportive to the PPP.

3. The Data
In this quest the data used to test the existence of long-run purchasing power parity was collected from the database of the School of Economics and Finance, Queen Mary University of London. As stated earlier, for this study, the UK and India has been chosen as the country of experiment. Where UK is the domestic country and India is the foreign country. Two basic time series variables are used for the test: the nominal exchange rate and consumer price index (CPI). The nominal exchange rates are then used to obtain real exchange rates. High frequency monthly and quarterly time series data are used where both monthly and quarterly data are spanning the period of January 1970 to December 2009 which is 40 years. The dataset includes 480 observations in monthly and 160 observations in quarterly data for both the nominal exchange rate and consumer price index (CPI). This quarterly data are used and tested to compare the result as a low frequency dataset with the test result of monthly data as a high frequency dataset. The 40 years of monthly dataset has been divided again in eight equal subsamples of 5 years; Subsample 1 - 1970 to 1974 Subsample 2 - 1975 to 1979 Subsample 3 - 1980 to 1984 Subsample 4 - 1985 to 1989 Subsample 5 - 1990 to 1994 Subsample 6 - 1995 to 1999 Subsample 7 - 2000 to 2004 Subsample 8 - 2005 to 2009 Each of those subsamples has then tested to perform subsample analyses to check the validity of purchasing power parity in short run. So the study is basically a comparative analysis between high and low frequency data and also between long and short horizon data with the effect on both long and short-run existence of purchasing power parity. 3.1. Descriptive Statistics of the Data A basic descriptive statistical analysis of the independent variables which are the CPI of UK, CPI of India and the nominal exchange rate between UK and India of 1970 to 2009 monthly data is shown bellow.

International Research Journal of Finance and Economics - Issue 70 (2011)

Figure 1: Descriptive statistics of the variables of monthly dataset (1970-2009)
50 Series: CPI_UK Sample 1970M01 2009M12 Observations 480 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 20 40 60 80 100 60.36083 62.05000 113.8000 9.300000 31.67576 -0.102811 1.764618 31.36897 0.000000
80 70 60

132

40

Series: CPI_INDIA Sample 1970M01 2009M12 Observations 479 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 20 40 60 80 100 120 140 47.58685 32.80000 144.6000 6.700000 37.01460 0.684460 2.198966 50.20717 0.000000

30

50 40 30 20 10 0

20

10

1.a) CPI of UK
100

1. b) CPI of India
Series: E Sample 1970M01 2009M12 Observations 480 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 0.036298 0.035751 0.070671 0.011263 0.020655 0.106355 1.298863 58.78221 0.000000

80

60

40

20

0 0.0125 0.0250 0.0375 0.0500 0.0625

1.c) Nominal exchange rate

The table 1 bellow represents the summery of the descriptive statistics of the variables. From the table it can be easily interpreted that on a comparative scale in most of the cases Indias price level seems to be more volatile than that of UK. The standard deviation of the consumer price level of India is much larger than the UK but on the other hand there is not much difference in the kurtosis value indicating the presence of sudden jumps in the data which are almost similar throughout the time series.
Table 1: Summery of descriptive statistics of the monthly and quarterly datasets
VARIABLES CPI of UK CPI of India Nominal exchange rate CPI of UK CPI of India Nominal exchange rate MEASURES St. Dev. 31.675760 37.014600 0.020655 31.744100 36.643290 0.020770 Skewness -0.102811 0.684460 0.106355 -0.103082 0.670209 0.113449 Kurtosis 1.764618 2.198966 1.298863 1.764484 2.148986 1.300192 Jarque-Bera 31.368970 50.207170 58.782210 10.460020 16.701280 19.605520

DATASETS Monthly data (1970-2009)

Quarterly data (1970-2009)

The value of Jarque-Bera test statistics indicate that the data are not normally distributed. The Jarque-Bera test statistic measures the difference of the skewness and kurtosis, also known as the excess kurtosis, of the series with those of a normally distributed series. Moreover, the skewness and kurtosis of the variables do not match the criteria of a normal distribution (for normal distribution skewness should be zero and kurtosis should be three). However, the statistics show that the nominal exchange rate series are not normally distributed as well. Furthermore, the data also indicates a gradual rising trend for both the UK and Indias consumer price indices but a gradual decrease of the nominal exchange rate for the given time period.

133

International Research Journal of Finance and Economics - Issue 70 (2011)

Figure 2: Graphical representation of the three variables of monthly data used in the analysis
160 140 120 100 80 60 40 20 0 1970 1975 1980 1985 1990 1995 2000 2005 20 0 1970 1975 1980 1985 1990 1995 2000 2005 80 .05 60 .04 40 .03 .02 .01 1970 1975 1980 1985 1990 1995 2000 2005 120 100 .08 .07 .06

CPI_INDIA

CPI_UK

4. Empirical Framework
The core agenda for carrying out this test is to find out whether the PPP holds in the long run or not and at the same time to make comparison between long and short-run effect on PPP. As mentioned in the previous section, PPP theory states that when calculated in the identical currency, the long run domestic and the foreign price levels are equal. Law of one price is at the heart of this theory under the assumption that all goods p r o d u c e d i n t h o s e c o u n t r i e s are tradable, zero transport costs, no barriers to trade, perfect homogeneity of domestic and foreign goods and market, and (usually) perfect competition. This law says that free trade must lead to equal prices across countries (Rogoff, 1996). The purchasing power parity theory also tells us that the movement in price levels should be cointegrated with the movement in nominal exchange rates between comparing countries. In a nutshell, if the price level goes up the exchange rate should go up and similarly if the price level goes down the exchange rate should go down. Now to check whether this assertion holds in the long run or not, the following procedures should be under taken. 4.1. Correlogram The first thing to determine before we actually start the analysis is to check the correlogram of the variables which is the first step to verify whether the time series data is stationary or not. This is the preliminary step before going to the unit root test to check the stationarity. It would enable us to generate autocorrelation which refers to the correlation of a time series with its own past and future values. To test the hypothesis of stationarity from the correlogram the decision rule is usually the autocorrelation function of a stationary process gradually decays to zero. So if the autocorrelation function of the time series variable does not follow the rule the time series will be non-stationary. 4.2. Unit Root Test for Stationarity The next step of testing the purchasing power parity is to verify the real exchange rate whether it is stationary or not. The evidence will support PPP if the real exchange rate is stationary and does not follow random walk, but if the real exchange rate is not stationary the evidence will not support PPP because it follows random walk. Most of the empirical studies start from testing the stationarity and unit root test of the variables with correct deterministic specification of levels, differences and lags. For this study, the real exchange rate must be stationary to hold purchasing power parity. The basic Dickey-Fuller test and Augmented Dickey-Fuller (ADF) test is used where the general regression is; (2) yt = + t + yt-1 + 1yt-1 + ..... + pyt-p + t The null hypothesis has been set that the real exchange rate has unit root which represents that the real exchange rate is non-stationary. According to the above regression model for the real exchange rate to be a random walk the value of beta () has to be equal to zero. So the null hypothesis is H0 : 0

International Research Journal of Finance and Economics - Issue 70 (2011)

134

The equalling zero corresponds to the situation where the random walk hypothesis persists. Since we have to check for the possibility that the long run PPP holds, if the null hypothesis prevails, it would mean that the data is non stationary. The alternative hypothesis is H1 : 0 In the case of rejection of the null hypothesis, there exists a trend in the time series which needs to be addressed. The methodology hence used is to find the first level difference for the given data set in order to remove the random walk. General decision rule for the unit root test is if the t-value from the ADF test statistics is higher than the critical values then we do not reject the null and if the t-value is smaller than the critical value then the null hypothesis will be rejected. The acceptance of null hypothesis means the series has unit root and is non-stationary or we can also say that the series follows random walk implying that the purchasing power parity do not hold and the opposite result will be found in case of the rejection of the null hypothesis. It is important to employ the correct lag number to get accurate estimation for both levels and first differences. In both cases we include trend and intercept only if the probability value for the trend is lower than 0.05 that is 5% otherwise we include only intercept. While testing the unit root of the residual series we include none for the exogenous regressors. 4.3. Co-Integration Test An (n1) vector time series yt (e.g. exchange rates and price indices) is said to be co-integrated if each of its elements individually is integrated of order 1, i.e. non-stationary with one unit root, and there exists a nonzero (n1) vector a such that a yt is stationary. In this case, a is called the co-integrating vector (Hamilton, 1994). Co-integration implies that the variables are individually non-stationary but one or more linear combination of the variables is stationary (Dickey et al., 1991). From the unit root test of stationarity if the consumer price index and exchange rates are found to be non-stationary variables then there is rational to execute the co-integration test. Through co-integration we can determine whether there exists any form of relationship between the variables even if there is existence of random walk individually. Co-integration is a property of time series variables. Even if the given variables are non stationary themselves, the series would be stationary if the linear combination of the series is stationary. The co-integration analysis facilitates in testing a long-run relationship between two variables. The main benefit of co-integration test is that a stable long-run equilibrium relationship can be found out among the non-stationary time series variables by this process. In the short run, cointegration also finds out and ignores the short-run dynamics that prohibits the relationship to hold. Here we need to clarify some facts about the co-integration test because economists are still in confusion about the use of co-integration to test the purchasing power parity. Sometimes economists use it to establish the long-run equilibrium relationship among relevant variables for example price levels and exchange rates. However, if the dataset is not detailed enough the test can not establish any ex ante equilibrium relationship. Co-integration test can only explain the presence of a long-run ex post stable relationship between the variables (Enders, 1995, p. 359). Engle-Granger and Johensens approaches are most commonly used among different available approaches for the co-integration tests. The Engle-Granger two-step test, actually based on ordinary least square (OLS) method, developed by Engle and Granger in 1987 and the second one is maximum likelihood method proposed by Johansen (1988) which is based on VAR approach. Engle and Granger (1987) stated that if two non-stationary variables are integrated of the same order l(d), there will exist a co-integrating relationship between the two variables given that the residual is stationary. Hence this is known as a two step testing where first we run a regression and save residuals, and then Augmented Dickey-Fuller unit root test is applied on the residual to check for the presence of stationarity. Yt = + Xt + ut (3) Where Yt is the dependant variable which is the exchange rate in our case, and Xt would be the independent variable. In our analysis since we have used two independent variables that is the CPI of

135

International Research Journal of Finance and Economics - Issue 70 (2011)

is a ( K 1) vector of I (1) vari ables in our case yt = [st , pt /pt ] , and is a (d 1) Where vector of determi nistic variables, for example, intercept a nd trend. Here the vector auto regression can be rewritten as; p 1 (5) + y = II y + Bx + E r y
t t 1 i 1 i t 1 t t

both India and Uk, the equation involves another variable as well. The hypothesis hence for this test will take the following form; Ho: variables are not co-integrated H1: variables are co-integrated In order for PPP to hold in the long run, the null hypothesis here should be rejected. Johansens maximum likelihood method is more popular to perform co-integration test in case of more than two time series variables because it considers the number of co-integrating vectors. More importantly it is possible to get evidence of more than one co-integrating relationship between the variables by Johansens approach. Another reason of its popularity is it involves less error than the Engle-Granger method because it has only one step where as the Engle-Granger method has two steps and the Engle-Granger procedure cannot find out more than one co-integrating relation. Johansens test considers the following Vector Auto Regression (VAR) of order p: y t = A1Yt 1 + + AP y t p + Bx t + t (4)

Where,

p = A i I , and i =1

p ri = Aj i = i +1

Then if the rank of is r < k, there exist r co-integrating relationships between the k variables. In our case, k = 3, then r can be either 2 or 1 representing two or one co-integrating relationship which means PPP holds or 0 representing no co-integrating relationship, which means PPP does not hold. The Johansens co-integration test allows us to test more than one null hypothesis. In our case, we test three sets of hypotheses that are as follows: First Null hypothesis: No co-integration Alternative hypothesis: At least one co-integrating relationship Second Null hypothesis: One co-integrating relationship Alternative hypothesis: Two co-integrating relationship Third Null hypothesis: Two co-integrating relationship Alternative hypothesis: Three co-integrating relationship So, Johansens method is a sequential approach where sets of hypothesis are tested. We can carry on successively from r = 0 to r = k-1 until we fail to reject. The necessity of the Vector Error Correction (VEC) arises when there is co-integrating relationship among the variables. Essentially vector error correction models are based on the vector auto-regression and include error correction terms. The intension behind the VEC is to check whether there is error correction mechanism in the time series variables. The short-run disequilibrium in one period can be removed in the next period by this error correction mechanism. Thus the VEC method is a way to bring together the short and long run behaviour of the variables. It is necessary to run the Johansens co-integration test before performing VEC because it allows us to find out if there is any co-integrating relationship among the variables and also to determine the number of co-integrating equations.

International Research Journal of Finance and Economics - Issue 70 (2011)

136

5. Results and Discussion

As we discussed in the data description section, total ten datasets have been used in this study which are monthly data of from 1970 to 2009, quarterly data of from 1970 to 2009 and eight sub samples of the monthly data from 1970 to 1974, 1975 to 1979, 1980 to 1984, 1985 to 1989, 1990 to 1994, 1995 to 1999, 2000 to 2004 and 2005 to 2009 that are obtained by dividing the main monthly dataset. Each dataset comprises of two variables for both UK and India which are consumer price index (CPI) and the country wise exchange rate. These CPI and exchange rates are then used to derive the relative price levels and nominal exchange rates for both countries. According to the PPP assertion that price level and exchange rates move together, we do not get positive evidence for all the datasets. For instance, if we look at the following two figures (figure 5 and 6), we find that in both cases relative price and exchange rates are moving together but according to the test result, which will be describe in detail later on, PPP holds for the monthly dataset whereas for the quarterly dataset PPP does not hold. Similarly for some of the subsamples this PPP assertion holds and for some does not, although the subsamples are made from the same monthly dataset of from 1970 to 2009.
Figure 3: Relative price and exchange rate from monthly dataset (1970 - 2009)
2.5 .08 .07 2.0 .06 .05 1.5 .04 1.0 .03 .02 0.5 1970 1975 1980 1985 1990 1995 2000 2005 .01 1970 1975 1980 1985 1990 1995 2000 2005

RP

Figure 4: Relative price and exchange rate from quarterly dataset (1970 - 2009)
2.5 .07 .06 2.0 .05 1.5 .04 .03 1.0 .02 0.5 1970 1975 1980 1985 1990 1995 2000 2005 .01 1970 1975 1980 1985 1990 1995 2000 2005

RP

For all the variables in this analysis, testing for the correlation has been done. The lags here were kept at the maximum level for better results. The autocorrelation for all the three variables show existence of stationarity in most of the datasets. In case of a stationary data the autocorrelation function should gradually descends down to almost zero, but in the case of only the monthly data it does not descend to zero when estimated with level and when estimated with 1st difference as well which implies that the data is not stationary. The first step of the formal analysis starts with the testing of the real exchange rate to find whether the real exchange rate is stationary or not. In this study the analysis was started with consumer price index (CPI) and exchange rates of the UK and India. The real exchange rate, denoted by q, has been derived from those data using following formula; q = log(exchange rate UK / exchange rate India) log(CPI UK/ CPI India) (6) The Augmented Dickey-Fuller (ADF) unit root test has been done on the real exchange rate to see whether the absolute PPP holds or not. The test is based on level and includes trend and intercept but in the case where trends probability is higher than 0.05, which is not significant, we include only intercept. The test has also been done on 1st difference to check whether the real exchange rates have

137

International Research Journal of Finance and Economics - Issue 70 (2011)

unit root at 1st difference as well or not. Here the null hypothesis (H0) is the real exchange rate has unit root. The purchasing power parity theory tells us that for the PPP to hold the real exchange rate should be stationary.
Table 2:
Datasets Monthly (1970-2009) Quarterly (1970-2009) Subsample 1 (1970-1974) Subsample 2 (1975-1979) Subsample 3 (1980-1984) Subsample 4 (1985-1989) Subsample 5 (1990-1994) Subsample 6 (1995-1999) Subsample 7 (2000-2004) Subsample 8 (2005-2009)

ADF unit root test results on the real exchange rates

ADF t-statistics -1.534307 -1.507563 -1.362689 -1.266480 -3.219463 -4.589772 -2.589723 -3.677262 -3.497682 -0.245420 1% -3.443805 -3.471987 -3.548208 -3.546099 -4.121303 -4.124265 -3.546099 -4.121303 -4.121303 -3.548208 Critical Values 5% -2.867367 -2.879727 -2.912631 -2.911730 -3.487845 -3.489228 -2.911730 -3.487845 -3.487845 -2.912631 10% -2.569936 -2.576546 -2.594027 -2.593551 -3.172314 -3.173114 -2.593551 -3.172314 -3.172314 -2.594027 Probabilities 0.5155 0.5274 0.5943 0.6394 0.0906 0.0026 0.1008 0.0318 0.0489 0.9260

According to the decision rule we accept the null hypothesis when ADF t-statistics is greater than the critical values. The ADF test report showing that the ADF test statistic for the monthly data is -1.534307 and probability value 0.5155. Whereas, the 1%, 5% and 10% critical values are -3.443805, 2.867367 and -2.569936 respectively. So, we do not reject the null hypothesis because the ADF test statistic has been found much greater than the critical values which implies that the real exchange rate has unit root and not stationary. In other word, the real exchange rate follows random walk. The summery from the table 2 represents that we do not reject null hypothesis only except for the subsample 4 (1985-1989). In this case null hypothesis is rejected at the 1st difference as well. So, the absolute PPP holds only between 1985 and 1999 which is subsample 4.
Table 3: DF test result of the real exchange rate of monthly data

Null Hypothesis: Q has a unit root Exogenous: Constant Lag Length: 0 (Automatic based on SIC, MAXLAG=17) Augmented Dickey-Fuller test statistic 1% level Test critical values: 5% level 10% level *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(Q) Method: Least Squares Date: 08/27/10 Time: 00:37 Sample (adjusted): 1970M02 2009M11 Included observations: 478 after adjustments Variable Coefficient Q(-1) -0.005099 C -0.021704 R-squared 0.004921 Adjusted R-squared 0.002831 S.E. of regression 0.030950 Sum squared resid 0.455960 Log likelihood 983.9829 Durbin-Watson stat 1.946884 t-Statistic -1.534307 -3.443805 -2.867367 -2.569936 Prob.* 0.5155

Std. Error t-Statistic 0.003324 -1.534307 0.013048 -1.663388 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic yProb(F-statistic)

Prob. 0.1256 0.0969 -0.001802 0.030994 -4.108715 -4.091269 2.354099 0.125618

International Research Journal of Finance and Economics - Issue 70 (2011)

Table 4: DF test result of the real exchange rate of subsample 4 (1985-1989)

138

Null Hypothesis: Q has a unit root Exogenous: Constant, Linear Trend Lag Length: 1 (Automatic based on SIC, MAXLAG=10) Augmented Dickey-Fuller test statistic Test critical values: *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(Q) Method: Least Squares Date: 08/26/10 Time: 18:27 Sample (adjusted): 1985M03 1989M12 Included observations: 58 after adjustments Variable Coefficient Q(-1) -0.440678 D(Q(-1)) 0.266075 C -1.550891 @TREND(1985M01) -0.003282 R-squared 0.293170 Adjusted R-squared 0.253902 S.E. of regression 0.024301 Sum squared resid 0.031890 Log likelihood 135.3729 Durbin-Watson stat 1.930073 1% level 5% level 10% level t-Statistic -4.589772 -4.124265 -3.489228 -3.173114 Prob.* 0.0026

Std. Error 0.096013 0.123933 0.335021 0.000775 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic)

t-Statistic -4.589772 2.146929 -4.629239 -4.233144

Prob. 0.0000 0.0363 0.0000 0.0001 -0.009158 0.028134 -4.530101 -4.388001 7.465808 0.000286

Now to move to the next step of the analysis, the testing for co-integration has been done between nominal exchange rate and consumer prices using both the Engle-Granger and Johansens approach. For the Engle-Granger procedure the first condition is all the variables used in the test should be co-integrated in the same order l(d). The following equation has been used to estimate that the log of nominal exchange rate, log of domestic price and the log of foreign price levels are first order co-integrated l(1). st = + (pt p*t) + ut (7) Where st denotes log of nominal UK/India exchange rate, pt denotes log of domestic (UK) price index, and p*t log of foreign (India) price index and and * are not constrained to be equal to 1. As found in the test variables are not co-integrated in order one for all the datasets. Variables of subsample 1, subsample 2, subsample 4, subsample 5, subsample 6 and subsample 8 are all co-integrated in order one, l(1). The logarithm of CPI of UK for both monthly and quarterly data is second order integrated. The logarithm of CPI of UK in subsample 3 is co-integrated of order zero and the logarithm of CPI of India in subsample 7 is also co-integrated of order zero. So, variables of these four datasets, monthly (1970-2009), quarterly (1970-2009), subsample 3 (1980-1984) and subsample 7 (2000-2004), are not co-integrated in the same order of l(1). The Engle-Granger regression has been run on all the ten datasets and we have got ten residual series. The residual series obtained from the Engle-Granger approach will have unit root if the variables are co-integrated. So again the ADF unit root test has been performed on the residual series under the null hypothesis that H0 : ut has unit root. This time the test again include level but no trend and/or intercept, we include only none for the exogenous variable, as we know that the residual series does not follow any trend which is also very clear in the graphical presentation of the residual series. In case of lag selection it has been found that the result does not change when the lag changed. So, we have used automatic selection by the software. Following (table 5) is the unit root test result of the residual series of monthly data (1970-2009).

139
Table 5:

International Research Journal of Finance and Economics - Issue 70 (2011)

Unit root test result of the residual series of monthly data (1970-2009)

Null Hypothesis: RESID01 has a unit root Exogenous: None Lag Length: 0 (Automatic based on SIC, MAXLAG=17) Augmented Dickey-Fuller test statistic Test critical values: *MacKinnon (1996) one-sided p-values. Augmented Dickey-Fuller Test Equation Dependent Variable: D(RESID01) Method: Least Squares Date: 08/27/10 Time: 00:42 Sample (adjusted): 1970M02 2009M11 Included observations: 478 after adjustments Variable RESID01(-1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood 1% level 5% level 10% level t-Statistic -1.912900 -2.569809 -1.941487 -1.616254 Prob.* 0.0533

Coefficient -0.009001 0.007071 0.007071 0.035644 0.606009 915.9898

Std. Error t-Statistic 0.004705 -1.912900 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Durbin-Watson stat

Prob. 0.0564 -0.000835 0.035770 -3.828409 -3.819686 1.822657

However, according to the ADF test reports (Summarised in Table 6) for all the ten residual series we do not reject the null hypothesis since the ADF test statistic is greater than all the three, 1%, 5% and 10% critical values. To get accurate result we have compared the ADF t-statistics with correct 1%, 5% and 10% critical values that are -3.98, -3.42 and -3.13 respectively and proposed by J.D. Hamilton (1994). These critical values are only applicable for the Dickey-Fuller t-statistic when applied to residuals from co-integrating regression and are tabulated in Table B.9 of his Time Series Analysis book.
Table 6:
Datasets Monthly (1970-2009) Quarterly (1970-2009) Subsample 1 (1970-1974) Subsample 2 (1975-1979) Subsample 3 (1980-1984) Subsample 4 (1985-1989) Subsample 5 (1990-1994) Subsample 6 (1995-1999) Subsample 7 (2000-2004) Subsample 8 (2005-2009)

ADF unit root test results on the residual series

ADF t-statistics -1.912900 -2.005326 -1.469487 -0.574734 -2.246205 -3.109746 -2.506718 -3.817386 -2.691369 -2.469576 1% -3.9800 -3.9800 -3.9800 -3.9800 -3.9800 -3.9800 -3.9800 -3.9800 -3.9800 -3.9800 Critical Values 5% -3.4200 -3.4200 -3.4200 -3.4200 -3.4200 -3.4200 -3.4200 -3.4200 -3.4200 -3.4200 10% -3.1300 -3.1300 -3.1300 -3.1300 -3.1300 -3.1300 -3.1300 -3.1300 -3.1300 -3.1300 Probabilities 0.0533 0.0434 0.1312 0.4642 0.0250 0.0024 0.0130 0.0003 0.0079 0.0143

So, now for more specific test and result there is rational to go for the Johansens co-integration test. As we know that the intention behind the co-integration test is to decide whether a group of nonstationary variables are co-integrated or not. The Johansens co-integration test allows us to test more than two variables together and at the same time more than one null hypothesis sequentially. Here, we test three null hypotheses that are as following; First null hypothesis: No co-integration Alternative hypothesis: One co-integrating relationship Second null hypothesis: One co-integrating relationship

International Research Journal of Finance and Economics - Issue 70 (2011)

140

Alternative hypothesis: Two co-integrating relationship Third null hypothesis: Two co-integrating relationship Alternative hypothesis: Three co-integrating relationship For the Johansens co-integration test, among the ten datasets, case 3 has been used under the deterministic trend assumption in eight datasets where we have got that all series have a stochastic trend, i.e. a unit root, and no additional exogenous variables and unchanged lagged difference. While in case of the other two datasets, subsample 3 and subsample 7, where some series are trend stationary case 4 has been used under the deterministic trend assumption. Following is the first part of Johansens co-integration test of the monthly data (1970-2009).
Table 7a: First part of Johansens co-integration test of the monthly data (1970-2009)
Date: 08/27/10 Time: 00:43 Sample (adjusted): 1970M06 2009M11 Included observations: 474 after adjustments Trend assumption: Linear deterministic trend Series: LOG_CPI_INDIA LOG_CPI_UK LOG_E Lags interval (in first differences): 1 to 4 Unrestricted Cointegration Rank Test (Trace) Hypothesized Trace No. of CE(s) Eigenvalue Statistic None * 0.075860 43.03182 At most 1 0.007790 5.637303 At most 2 0.004064 1.930258 Trace test indicates 1 cointegrating eqn(s) at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values

0.05 Critical Value 29.79707 15.49471 3.841466

Prob.** 0.0009 0.7379 0.1647

The test report (Table 7a) shows that for the first null hypothesis Johansens test statistic is 43.03182 but 5% critical value is 29.79707 with probability 0.0009. So, the first null hypothesis is rejected. For the second null hypothesis 5% critical value is 15.49471 whereas the Johansens test statistic is 5.637303 with probability 0.7379. In this case we do not reject the null hypothesis which means that there is one co-integrating relationship between the variables. However, the following table (Table 7b) is showing that for the quarterly data (1970-2009) Johansens test statistic is 24.98414 but 5% critical value is 29.79707 with probability 0.1620 for the first null hypothesis and here we do not reject the null hypothesis which means there is no co-integrating relationship between the variables.
Table 7b: First part of Johansens co-integration test of the Quarterly data (1970-2009)
Date: 08/27/10 Time: 03:35 Sample (adjusted): 1971Q2 2009Q3 Included observations: 154 after adjustments Trend assumption: Linear deterministic trend Series: LOG_CPI_INDIA LOG_CPI_UK LOG_E Lags interval (in first differences): 1 to 4 Unrestricted Cointegration Rank Test (Trace) Hypothesized No. of CE(s) Eigenvalue None 0.084689 At most 1 0.046915 At most 2 * 0.025365 Trace test indicates no cointegration at the 0.05 level * denotes rejection of the hypothesis at the 0.05 level **MacKinnon-Haug-Michelis (1999) p-values

Trace Statistic 24.98414 11.35653 3.956592

0.05 Critical Value 29.79707 15.49471 3.841466

Prob.** 0.1620 0.1905 0.0467

141
Table 8:

International Research Journal of Finance and Economics - Issue 70 (2011)

Summary of Johansens co-integration test of all ten datasets
None (No Co-integration) 5% crit. t-stat Prob value 29.797070 0.0009 43.031820 24.984140 29.797070 0.1620 22.926660 29.797070 0.2497 29.797070 0.0091 35.784230 32.523040 42.915250 0.3607 29.797070 0.0395 30.676600 29.797070 0.0021 40.348610 29.797070 0.0093 35.712680 42.915250 0.0412 43.745840 22.151980 29.797070 0.2901 HYPOTHESIZED NO. OF CE(S) At most 1 (One Co-integration) 5% crit. t-stat Prob value 5.637303 15.494710 0.7379 11.356530 15.494710 0.1905 11.102910 15.494710 0.2053 13.341540 15.494710 0.1029 16.960530 25.872110 0.4179 7.338203 15.494710 0.5386 12.515070 15.494710 0.1338 12.332950 15.494710 0.1417 17.625600 25.872110 0.3696 7.159556 15.494710 0.5592 At most 2 (Two Co-integration) 5% crit. t-stat Prob value 1.930258 3.841466 0.1647 3.956592 3.841466 0.0467 3.091230 3.841466 0.0787 0.114357 3.841466 0.7352 7.776977 12.517980 0.2704 0.251848 3.841466 0.6158 3.089404 3.841466 0.0788 1.138253 3.841466 0.2860 6.096987 12.517980 0.4481 0.068884 3.841466 0.7930

DATASETS Monthly Quarterly Subsample 1 Subsample 2 Subsample 3 Subsample 4 Subsample 5 Subsample 6 Subsample 7 Subsample 8

According to the Johansens co-integration test results (Table 8), six out of all ten datasets (marked as bold) including monthly data of from 1970 to 2009 are found to have one co-integrating relation and rest of the four datasets including quarterly data of from 1970 to 2009 are found to have zero co-integrating relationship among the variables. At this stage we have partial evidence on both in favour and against the theory of purchasing power parity as the Engle-Granger two step approach shows no co-integration and the Johansens maximum likelihood approach shows at least one cointegrating relation between variables for most of the datasets. So, now there is rational to run Vector Error Correction (VEC here after) to check whether there is error correction mechanism within the data. Table 9 is showing a part of the estimate output of VEC of 1970 to 2009 monthly data.
Table 9: Vector error correction estimate of monthly data (1970-2009)

Vector Error Correction Estimates Date: 08/28/10 Time: 01:10 Sample (adjusted): 1970M04 2009M11 Included observations: 476 after adjustments Standard errors in ( ) & t-statistics in [ ] Cointegrating Eq: CointEq1 LOG_E(-1) 1.000000 LOG_CPI_UK(-1) -2.078135 (0.60871) [-3.41397] LOG_CPI_INDIA(-1) 1.115607 (0.48764) [ 2.28775] C 7.703139 Error Correction: D(LOG_E) CointEq1 0.001055 (0.00145) [ 0.72805]

D(LOG_CPI_UK) 0.001939 (0.00029) [ 6.65023]

D(LOG_CPI_INDIA) -0.000474 (0.00044) [-1.06768]

To estimate VEC model we have used 1 2 lag interval as endogenous variable and no exogenous variables. The first part of table 9 is representing the Standard errors in ( ) and t-statistics in [ ]. As we know that the t-statistics obtained from the VEC test report should be greater than the critical value 1.96 to prove the presence of error correction mechanism as the first criteria. The second criterion is that the difference between those two t-statistics should be a negative value. In this analysis error correction mechanism has not been found in any of the subsample datasets even where cointegration is present. Whereas, in case of the long-run monthly dataset the test report is showing that the t-statistics of CPI of UK is [-3.41397] and the t-statistics of CPI of India is [2.28775] which is greater than 1.96 in absolute value. Moreover, the difference between those two t-statistics is a

International Research Journal of Finance and Economics - Issue 70 (2011)

142

negative value which indicates the presence of error correction mechanism in long run monthly dataset. Table 10 represents the summarised results of the statistical analysis including the vector error correction report of all ten datasets.
Table 10: Summary of the statistical analyses of all the ten datasets
Datasets Monthly (1970-2009) Quarterly (1970-2009) Subsample 1 (1970-1974) Subsample 2 (1975-1979) Subsample 3 (1980-1984) Subsample 4 (1985-1989) Subsample 5 (1990-1994) Subsample 6 (1995-1999) Subsample 7 (2000-2004) Subsample 8 (2005-2009) Real Ex. Rate (Q) NS NS NS NS NS S NS NS NS NS Unit Root Tests Log of Log of CPI India CPI UK l(1) l(1), l(2) l(1) l(1), l(2) l(1) l(1) l(1) l(1) l(1) l(0) l(1) l(1) l(1) l(1) l(1) l(1) l(0) l(1) l(1) l(1) Log of e* l(1) l(1) l(1) l(1) l(1) l(1) l(1) l(1) l(1) l(1) Residua l Series NS NS NS NS NS NS NS NS NS NS Johansen's Cointegration test (No of eqns) 1 0 0 1 0 1 1 1 1 0 Error Correction Mechanism Present Absent Absent Absent Absent Absent

Notes: NS = Non-stationary S = Stationary * e = Nominal exchange rate

l(0) = Not integrated/Stationary l(1) = First order integrated l(2) = Second order integrated

These test results meet the criteria to conclude that there is error correction mechanism present in the variables of monthly data which helps to build up the equilibrium relationship in the long-run even though there is disequilibrium in the short-run subsamples.

6. Conclusion
In this study the monthly dataset from 1970 to 2009 has been used as the main dataset for the analysis. From this monthly dataset the main objective of this study was to test whether the purchasing power parity hypothesis holds in the long-run or not. However, at the same time the quarterly data from 1970 to 2009 and other eight subsample datasets have been used to compare the result between long and short run PPP and also the impact of the frequency of the observations. Although the test result is not straight forward, we found that there is co-integration in case of monthly (1970-2009) data which implies that PPP holds in the long-run but in case of quarterly data PPP does not hold. The monthly dataset includes 480 observations whereas the quarterly dataset comprises of only 160 observations. So, the result obtained from the analysis indicates that the frequency of the observations in the data series significantly affect the result although both the datasets are of same time period from 1970 to 2009. Some other researchers have found similar result, e.g. Frankel (1990). Results obtained from the subsamples are also mixed. Some subsamples showed that PPP holds in the short-run as well and some showed that PPP does not hold in the short-run. As stated earlier in this study that these subsamples are obtained by dividing the main monthly data in eight equal sub sections of five years. So, as PPP holds in long-run monthly data and does not hold in some of the short-run subsamples, it can be inferred that there exists some short-run disequilibrium among the variables although the main long-run monthly dataset is showing long-run equilibrium relationship. This proves that, there must be some error correction mechanism which is correcting the short-run disequilibria to establish the equilibrium relationship in the long-run. The vector error correction estimations result has found the presence of partial short-run adjustments coefficient which is responsible for the error correction and finally the equilibrium relationship in the long-run.

143

International Research Journal of Finance and Economics - Issue 70 (2011) Abuaf, N. & Jorion, P., 1990. Purchasing Power Parity in the Long Run. The Journal of Finance, VOL. XLV, NO. 1, pp. 157-174. Adler, M. & Lehmann, B., 1983. Deviations from purchasing power parity in the long run, Journal of Finance, Vol. 38, pp. 1471-1487. Bleaney, M., 1991. Does long-run purchasing power parity hold within the European monetary system? Journal of Economic Studies, Vol. 19, pp. 6672. Bleaney, M., 1992. A Test of Long-run Purchasing Power Parity Using Annual Data from Seven Countries, 1900-88. Economia Internazionale, Vol. XLV, pp. 180-95. Cassel, G., 1918. Abnormal deviations in international exchanges, The Economic Journal, pp28 Cheung, Y.W. & Lai, K., 1993. A fractional cointegration analysis of purchasing power parity. Journal of Business and Economic Statistics, Vol. 11, pp. 103112. Chortareas, G.E., Kapetanios, G. & Shin, Y., 2002. Nonlinear mean reversion in real exchange rates, Economics Letters, Vol. 77, pp. 411417. Chortareas, G. & Kapetanios, G., 2003. The Yen real exchange rate may be stationary after all: evidence from nonlinear unit roots, Department of Economics, Working Paper Series, University of London. Dickey, D.A., Jansen, D.W. & Thornton, D.L., 1991. A primer on cointegration with an application to money and income. Fed. Reserve Bank St. Louis Rev. March:April, 5878. Enders, Walter, 1995. Applied Econometric Time Series, New York, NY: John Wiley and Sons. Engle, Robert; Granger, C. W. J., 1987. "Cointegration and Error Correction: Representation, Estimation and Testing," Econometrica, S5, pp. 251-76. Fleissig, A.R. & Strauss, J., 2000. Panel unit root tests of purchasing power parity for price indices, Journal of International Money and Finance, Vol. 19, pp. 489506. Flynn, N.A. & Boucher, J.L., 1993. Tests of long run purchasing power parity using alternative methodologies, Journal of Macroeconomics, Vol. 15, pp. 109122. Frankel, J.A., 1990. Zen and the Art of Modern Macroeconomics: A Commentary, Monetary policy for a volatile global economy. Eds.: Haraf, W.S. and Willet, T.D., Washington DC, American Enterprise Institute for Public Policy Research, pp. 117-123. Frankel, J.A. & Ross, A.K., 1996. A panel project on purchasing power parity: mean reversion within and between countries, Journal of International Economics, Vol. 40, pp. 209224. Grilli, V. & Kaminsky, G., 1991. Nominal exchange rate regimes and the real exchange rate: evidence from the United States and Great Britain 18851986, Journal of Monetary Economics, Vol. 27, pp. 191212. Hamilton, J.D., 1994. Time Series Analysis. Princeton University Press, Princeton, NJ. Ho, T.W., 2002. Searching stationarity in real exchange rates: application of the SUR estimator, Open Economies Review, Vol. 13, pp. 275289. Johansen, Soren., 1988. "Statistical Analysis of Cointegrating Vectors," Journal of Economic Dynamics and Control, pp. 231-54. Karfakis, C. & Moschos, D., 1989. Testing for long run purchasing power parity, Economics Letters, Vol. 30, pp. 245248. Kilian, L. & Talyor, M.P., 2003. Why is it difficult to beat the random walk forecast of exchange rates, Journal of International Economics, Vol. 60, pp. 85107. Kim, Y., 1990. Purchasing Power Parity in the Long Run: A Cointegration Approach. Journal of Money, Credit and Banking, Vol. 22, pp. 491-503. Kim, Y., 1990. Purchasing power parity: another look at the long-run data, Economics Letters, Vol. 32, pp. 339344. Krugman, P.K. and Obstfeld, M., (2009). International Economics: Theory and Policy. 8th ed. Pearson Education.

References
[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16] [17] [18] [19] [20] [21] [22] [23] [24]

International Research Journal of Finance and Economics - Issue 70 (2011) [25] [26] [27] [28] [29] [30] [31] [32] [33] [34] [35] [36] [37] [38] [39] [40] [41] [42] [43] [44] [45]

144

Kugler, P. & Lenz, C., 1993. Multivariate cointegration analysis and the long-run validity of PPP. The Review of Economics and Statistics, Vol. 75, No. 1, pp. 180184. Layton, A.P. & Stark, J.P., 1990. Co-integration as an empirical test of purchasing power parity, Journal of Macroeconomics, Vol. 12, No. 1, pp. 125-136. MacDonald, R., 1988. Purchasing Power Parity: Some Long-run Evidence from the Recent Float. De Economist, Vol. 136, pp. 239-52. Mark, N.C., 1990. Real and nominal exchange rates in the long run: an empirical investigation, Journal of International Economics, Vol. 28, pp. 115136. McNown, R. & Wallace, M.S., 1989. National Price Levels, Purchasing Power Parity and Cointegration: A Test of Four High Inflation Countries. Journal of International Money and Finance, Vol. 8, pp. 533-45. Moosa, I.A., 1994. Testing Proportionality, Symmetry and Exclusiveness in Long-run PPP. Journal of Economic Studies. Vol. 21 No. 3, pp. 3-21. Narayan, P.K., (2006), Are bilateral real exchange rates stationary? Evidence from Lagrange multiplier unit root tests for India, Applied Economics, Vol. 36, PP.63-70. OConnell, P., 1998. The overvaluation of purchasing power parity, Journal of International Economics, Vol. 44, pp. 119. Officer, L., 1976. The purchasing power parity theory of exchange rates: A review article, International Monetary Fund Staff Papers 23, 1-60. Officer, L.H., (2006), Purchasing Power Parity: From Ancient Times to World War II, EH.Net Encyclopedia, Economic History Services, EH.Net, pp.79 Ong, L.L., 2003. The Big Mac Index: Application of Purchasing Power Parity, New York: Palgrave MacMillan. Pakko, M.R and Pollard, P.S., 2003. Burgernomics: A Big Mac Guide to Purchasing Power Parity, The federal Reserve Bank of St. Louis, pp 9-12 Papell, D.H. & Theodoridis, H., 1998. Increasing evidence of purchasing power parity over the current float, Journal of International Money and Finance, Vol. 17, pp. 4150. Patel, J., 1990. Purchasing power parity as a long run relation, Journal of Applied Econometrics, Vol. 5, pp. 367379. Pippenger, M.K., 1993. Cointegartion tests of purchasing power parity: The case of Swiss exchange rates. Journal of International Money and Finance, Vol. 12, pp. 4661. Rogoff, K., (1996), The Purchasing Power Parity Puzzle, Journal of Economic Literature, Vol. XXXIV, pp. 647-668. Samuelson, P., 1964. Theoretical notes on trade problems, Review of Economics and Statistics, Vol. 23, pp. 1-60. Sarno, L., Taylor, M.P. & Chowdhury, I., 2004. Nonlinear dynamics in deviations from the law of one price: a broad-based empirical study, Journal of International Money and Finance, Vol. 23, pp. 125. Serletis, A. & Gogas, P., 2004. Long-horizon regression tests of the theory of purchasing power parity. Journal of Banking & Finance, Vol. 28, pp.19611985. Taylor, M. P., 1988. An empirical examination of long run purchasing power parity using cointegration techniques, Applied Economics, Vol. 20, pp. 13691381. Taylor, M. P., Peel, D. A. & Sarno, L., 2001. Nonlinear mean reversion in real exchange rates: towards a solution to the purchasing power parity puzzles, International Economic Review, Vol. 42, pp. 10151042.