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A Century of Purchasing-Power Parity

A Century of Purchasing-Power Parity. by Alan Taylor presentation by Andreea Chiritescu. Previous studies about PPP. McCloskey and Zecher (1984) – PPP worked very well under the Anglo-American gold standard before 1914

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A Century of Purchasing-Power Parity

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  1. A Century of Purchasing-Power Parity by Alan Taylor presentation by Andreea Chiritescu

  2. Previous studies about PPP • McCloskey and Zecher (1984) – PPP worked very well under the Anglo-American gold standard before 1914 • Diebold, Husted, and Rush (1991) – support for PPP based on the low-frequency information lacking in short-sample studies • Abauf and Jorion (1990) – studied a century of dollar-franc-sterling exchange rate data and verified PPP • Lothiam and M.P. Taylor (1996) – studied two centuries of dollar-franc-sterling exchange rate data and verified PPP • Lothiam (1990) – real exchange rates were stationary for Japan, US, UK and France for 1875-1986 • Lee (1978) and Officer (1982)- strong evidence in favor of PPP based on analysis of long time series

  3. Previous studies about PPP • Recent empirical research, mostly based on the time-series analysis of short spans of data for the floating rate era, led many to conclude that PPP failed to hold, and that real exchange rate followed a random walk • Newly emerging literature exploits more data and higher-powered techniques, and claims that, in the long-run, PPP does indeed hold: real exchange rates exhibit mean reversion with a half-life of deviations of four to five years

  4. Introduction • This study brings very recent empirical innovations to a longer span of historical data • To investigate the robustness of the recent findings • To explore the historical evolution of PPP • Old-style univariate tests • Multivariate test of PPP by M.P. Taylor and Sarno (1998) • Univariate efficient tests of Elliot, Rothenberg, and Stock (1996)

  5. Data and preliminary analysis • i =1…20 countries • t = years from 1850 to 1996 • Eit = annual exchange rate (domestic currency/ US dollar) • Pit = price index (consumer price deflators) • eit = log Eit = the log level of annual exchange rate • pit = log Pit = the log level of price index • Rit = Pit / Eit = the US dollar-denominated price level of country i at time t • rit = log Rit = pit = eit • Due to missing data for some countries, they used linear interpolation on rit , so they had 20*105 panel of data from 1892 to 1996

  6. Data and preliminary analysis The real exchange rate series was generated in two ways: • Relative to the US dollar: qit = rit - rUS,t • Relative to the ‘world’ (N=20) basket of currencies: qwit = rit – rwit where • The complete series qit and qwit are shown in figure 1. • Test the PPP hypothesis: are these real exchange rates stationary?

  7. Traditional unit-root tests Test the PPP hypothesis: are these real exchange rates stationary? • The augmented Dickey-Fuller (ADF) unit root tests to the univariate real exchange rates • Results as expected, given the findings in the previous literature • A simple OLS regression on a constant and a trends seems to indicate that, for at least some of the series a deterministic trend might be present: • This trend component is sizable 1.5% per year in the case of Japan, 0.74% per year in the case of Switzerland, but is less than 0.5% per year in all other cases Even though they use more than a century of data (so the test should be reasonably powerful), they are unable to find broad evidence of stationarity

  8. A Multivariate Test • If PPP holds among a set of N+1 countries, then every single log real exchange rate, for all N(N+1)/2 bilateral pairs, is stationary • M.P. Taylor and Sarno (1998) test for the stationarity of exchange rate: a necessary and sufficient condition that all N series be stationary would be the existence of N independent cointegrating vectors among the series. • The cointegration methods of Johansen (1988, 1991) and Johansen likelihood ratio (JLR) test statistic

  9. A Multivariate Test, Conclusions: • JLR tests are somewhat favorable to the PPP hypothesis for most countries, but only when allowance is made for a trend, • Stationarity is accepted at a better than 10% significance level (except for Norway, which is under 10%), • The power of the test is low, and it falls dramatically when the trend is included, • Common problem in literature: the low power of tests to detect trend stationarity in favor of a unit root null • In the test without a trend, stationarity is rarely accepted (except for Denmark, Finland, Sweden, Australia and Canada – 5 out of 20) • So, the JLR tests suffer from the weak power problem

  10. A Univariate Test • The generalized-least-squares (GLS) versions of the Dickey-Fuller (DF) test • The results offer powerful support for the PPP hypothesis in the 20th century: PPP has held in the long-run over the 20th century for this sample of 20 countries. • Since PPP holds in the long-run, it is no longer productive to devote further attention to the stationarity question. • More important and interesting: to explain what drives short-run dynamics of real exchange rates

  11. An Overview of PPP in the 20th century1. What have been the extent of deviations from PPP over the long run? • Examine volatility via the size of changes in the real exchange rate qit (this change is proportional to the equilibrium + some error) • De-trend the series qit and examine the deviations of the resulting de-trended level qit (the error-correction term)

  12. An Overview of PPP in the 20th century1. What have been the extent of deviations from PPP over the long run? Gold standard era (prior to 1914): real exchange rate deviations and volatility were relatively small Interwar period (1914-1945): major turning point, deviations became much larger as many exchange rates began to float or stay fixed for only a few years Bretton Woods period (1945 - 1970): some reduction in deviations, notably the heyday of Bretton Woods during the ’60s Floating rate era (1970-1996): deviations and volatility rose again

  13. An Overview of PPP in the 20th century2. Why the deviations were larger or smaller at particular times? • Autoregressive model: • Results: • relatively small variations in half-lives across the four exchange rates regimes, but with exceptions: Italy and Germany in the interwar period, • The mean and median half-lives hover around 2-3 years, a time frame more favorable to rapid PPP adjustment Looking across the 20th century, and despite considerable differences in institutional arrangements and market integration across time and across countries, the deterministic aspects of persistence of PPP deviations have been fairly uniform in the international economy.

  14. An Overview of PPP in the 20th century3. What accounts for the dramatic changes in deviations from PPP? • Changes in the stochastic shocks explain virtually all changes in the volatility in the real exchange rate across space and time • Much larger shocks to the real exchange rate process under floating-rate regimes than under fixed rate regimes • The interwar period – an important turning point, PPP deviations shifted to dramatically higher levels. • The dominant source of PPP failure is nominal exchange rate volatility, that is, the nature of the monetary regime

  15. An Overview of PPP in the 20th century4. Why was this pattern of real and nominal exchange rate volatility observed in 20th century and implications • Macroeconomic policy trilemma, the well-known conflict facing policymakers when choosing between 3 competing objectives: • (i) A fixed exchange rate • (ii) Capital mobility • (iii) Activist monetary policy Where only 2 out of 3 are feasible • The gold standard: no monetary policy (iii) • The interwar: controls - sacrificing (ii) capital mobility, or devaluations -sacrificing (i) fixed exchange rate • Breton Woods: limited capital mobility- loss of (ii) • The float: brought back capital mobility at the expense of fixed rates, sacrificing (i)

  16. Conclusions Using the data for a group of 20 countries over 100 years: • The evidence for long-run PPP is favorable using recent multivariate and univariate tests of higher power • Residual variance analysis shows that that episodes of floating exchange rates have generally been associated with larger deviations from PPP, as expected (due to the larger shocks to the real exchange rate process in such episodes) • In the course of the 20th century, there was relatively little change in the capacity of international market integration to smooth out real exchange rate shocks • Instead, charges in the size of shocks depended on the political economy of monetary and exchange rate regime choice under the constraints imposed by the trilemma

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