DP1730 The Behaviour of Real Exchange Rates During the Post-Bretton Woods Period

Author(s):	Lucio Sarno, Mark P Taylor
Publication Date:	November 1997
Keyword(s):	Monte Carlo simulation, multivariate unit root test, Purchasing Power Parity, Real Exchange Rate, test power
JEL(s):	F31
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=1730

Tests for long-run purchasing power parity (PPP) may lack power with sample periods corresponding to the span of the recent float, leading researchers to use more powerful multivariate unit root tests. We point out a potential problem with such tests: joint non-stationarity of real exchange rates may be rejected when only one of them is stationary. We suggest another test where the null hypothesis is violated only when all of the processes are stationary. This test is easily constructed and has a known limiting distribution. We investigate the finite-sample empirical performance of both tests using Monte Carlo techniques. Applying the tests to four major real exchange rates over the recent floating rate period, we find strong evidence of long-run PPP.