Why Panel Tests of Purchasing Power Parity Should Allow for Heterogeneous Mean Reversion

CG (Kees) Koedijk, Ben Tims, Mathijs van Dijk

Research output: Contribution to journalArticleAcademicpeer-review

6 Citations (Scopus)

Abstract

Recent studies of purchasing power parity (PPP) use panel tests that fail to take into account heterogeneity in the speed of mean reversion across real exchange rates. In contrast to several other severe restrictions of panel models and tests of PPP, the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. This paper analyzes the properties of homogeneous and heterogeneous panel unit root testing methodologies. Using Monte Carlo simulation, we uncover important adverse properties of the panel approach that relies on homogeneous estimation and testing. More specifically, power functions are low and assume irregular shapes. Furthermore, homogeneous estimates of the mean reversion parameters exhibit potentially large biases. These properties can lead to misleading inferences on the validity of PPP. Our findings highlight the importance of allowing for heterogeneous estimation when testing for a unit root in panels of real exchange rates.
Original languageEnglish
Pages (from-to)246-267
Number of pages22
JournalJournal of International Money and Finance
Volume30
Issue number1
DOIs
Publication statusPublished - 2011

Research programs

  • EUR ESE 01
  • RSM F&A

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