Why Panel Tests of Purchasing Power Parity Should Allow for Heterogeneous Mean Reversion
October 2010
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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.
- heterogeneity
- Economic geography
- Economie en bedrijfskunde
- Economic sciences
- Maatschappelijke structuren en relaties
- PPP
- Economie
- panel models
- panel tests
- real exchange rates
- unit root tests
- F33 : International Monetary Arrangements and Institutions
- F31 : Foreign Exchange
- F47 : Forecasting and Simulation
- panel
- exchange rates
- reversion
- exchange
- parameter
- power
- reversion parameters
- methodology
- canada
- series
- reversion parameter
- unit root
- estimation
- figure
- value
- japan
- estimate
- power functions
- exchange rate
- hypothesis
