Purchasing power parity (PPP) is one of the most important theoretical concepts in international economics. Empirical work on the topic usually uses time series data to compare the percentage changes in bilateral exchange rates with inflation differentials. Many studies have been based on short or medium-length time series, often consisting of post-1973 observations for a few major industrialized countries. They typically did not find strong evidence of PPP. Concerned about inadequate power in their tests, researchers then turned to longer time samples. With these, the evidence has swung back in favour of some long-run tendency toward PPP. The consensus has emerged from this literature that there is in fact a moderate tendency for real exchange rates to converge towards a long-run equilibrium. The half-life of PPP deviations appears to be around four years. The long samples required for statistical significance are unavailable for most currencies, however, and may be inappropriate because of regime changes.

In Discussion Paper No. 1128, Jeffrey Frankel and Research Fellow Andrew Rose re-examine deviations from PPP using a panel of 150 countries and 45 annual observations. The panel shows strong evidence of mean reversion that is similar to that from long time-series. PPP deviations are eroded at a rate of approximately 15 per cent annually, that is their half-life is around four years. Such findings can be masked in time series data, but are relatively easy to find in cross-sections. The findings should be viewed as complementary to and consistent with those of the existing literature.

A Panel Project on Purchasing Power Parity: Mean Reversion Within and Between Countries
Jeffrey A Frankel and Andrew K Rose

Discussion Paper No. 1128, February 1995 (IM)