IMF Staff Papers - Volume 50, Number 3, 2003 - An Unbiased Appraisal of Purchasing Power Parity by Paul Cashin and C. John McDermott (December 2003)

Univariate studies of the hypothesis of unit roots in real exchange rates have yielded consensus point estimates of the half-life of deviations from purchasing power parity (PPP) of between three to five years (Rogoff, 1996). However, conventional least-squares-based estimates of half-lives are biased downward. Accordingly, as a preferred measure of the persistence of real exchange rate shocks we use median-unbiased estimators of the half-life of deviations from parity, which correct for the downward bias of conventional estimators. We study this issue using real effective exchange rate (REER) data for 20 industrial countries in the post–Bretton Woods period. The serial correlation-robust median-unbiased estimator yields a cross-country average of half-lives of deviations from parity of about eight years, with the REER of several countries displaying permanent deviations from parity. However, using the median-unbiased estimator that is robust to the moving average and heteroskedastic errors present in real exchange rate data reduces the estimated half-life of parity deviations. Using this unbiased estimator, we find that the majority of countries have finite point estimates of half-lives of parity deviation, which is supportive of PPP holding in the post–Bretton Woods period. We also find that the average bias-corrected half-life of parity deviations is about five years, which is consistent with (but at the upper end of) Rogoff’s (1996) consensus estimate of the half-life of deviations from parity. [JEL C22, F31]