Tests of purchasing power parity

Abstract

This paper examines the long-run relationship between exchange rates and prices in ten countries in Southwest Asia, Africa, and the Pacific Rim for the post-Bretton Woods period. It uses cointegration tests to investigate the thesis that relative purchasing power parity exists as a long-run equilibrium condition between country-pairs. It expands upon tests for relative purchasing power parity suggested by previous authors by pretesting price index time series for structural breaks, in addition to pretesting the price indices and exchange rates for compatible stochastic properties. It compares the results of conventional cointegration tests for parity with a weaker form of the relationship suggested by Pippenger (1993) and Patel (1990), and finally, examines purchasing power parity by testing real bilateral exchange rates for stationarity.