Does Purchasing Power Parity hold? New evidence from wild-bootstrapped nonlinear unit root tests in the presence of heteroskedasticity

a r t i c l e i n f o JEL classification: C10 C12 C22 C50 Keywords: (Nonlinear) unit root test Heteroskedasticity Wild bootstrapping Purchasing power parity In spite of the extensive research which has already been undertaken, the issue as to whether Purchasing Power Parity (PPP) empirically holds, continues to be strongly debated. Existing studies have been criticized for their reliance on unit root tests which are deemed to suffer from certain weaknesses such as the size distortion bias arising from heteroskedasticity. In this paper, we provide new evidence on PPP based on a new methodology that overcomes this problem. We use the widely accepted KSS (Kapetanios et al., 2003) non-linear unit root tests which we, however, wild bootstrapped. Through Monte Carlo simulation, we demonstrate that the wild-bootstrapped KSS is robust to heteroskedasticity-induced size distortion problem. We apply this method to test PPP across 61 countries over the period 1994 to 2012 — a period characterized by a number of crises such as the Asian Financial Crisis, Russian Crisis, dotcom crisis, Global Financial Crises, among others, and therefore, intense heteroskedasticity. Our results provide strong evidence against PPP. This paper contributes to both the international financial economics and econometrics literatures. Purchasing Power Parity (PPP), as first articulated by Cassel (1918, 1922), is one of the key assumptions in open macroeconomics and international finance models; however, after thirty years of intensive research , the empirical validity of PPP remains far from conclusive. PPP is a simple idea based on the law of one price which postulates that identical goods should sell at the same price in different countries and that the exchange rates between currencies will allow this to happen. In the absolute version of the PPP, the exchange rate would simply be the ratio of the price levels between countries. On the other hand, in the relative version of the PPP, the change in exchange rates offsets the differential in the relative change in prices between countries which implies that the real exchange rate (RER) will be stationary (see detailed discussion of PPP). Hence, the PPP hypothesis is typically examined by testing if RERs are stationary using unit root tests. Earlier studies, which were often based on the Dickey–Fuller (DF) tests, found little evidence to support PPP (e.g. Adler and Lehmann (1983)). The failure has been attributed to the low power of the DF tests and the literature has …