The so-called Balassa-Samuelson model implies that relative prices of non-traded goods may be nonstationary and, hence, that PPP should preferably be tested on real exchange rates based on prices of traded goods only. We propose a simple test for PPP among traded goods which can be applied to real exchange rates based on prices of all (that is, both traded and non-traded) goods. We show through simulations that the test is reliable for a sample size commonly considered in practice. Upon applying the test to bilateral real exchange rates based on the general CPI among a group of industrialized countries during the recent float, we find little evidence in favor of PPP among traded goods. This does not change when we use real exchange rates based on various components of the CPI.

Purchasing power parity, Unidentified nuisance parameters, Unit roots
hdl.handle.net/1765/585
Econometric Institute Research Papers
Erasmus School of Economics

Franses, Ph.H.B.F, & van Dijk, D.J.C. (2002). A simple test for PPP among traded goods (No. EI 2002-02). Econometric Institute Research Papers. Retrieved from http://hdl.handle.net/1765/585