Finance and Financial Management Commons^™

Purchasing Power Parity And Heterogeneous Mean Reversion, Kees G. Koedijk, Ben Tims, Mathijs A. Van Dijk

CRIF Seminar series

This paper analyzes the properties of multivariate tests of purchasing power parity (PPP) that fail to take heterogeneity in the speed of mean reversion across real exchange rates into account. We compare the performance of homogeneous and heterogeneous unit root testing methodologies. The recent literature has successfully contested several severe restrictions on the structure of the model, but the assumption of homogeneous mean reversion is still widely used and its consequences are virtually unexplored. Using Monte Carlo simulation, we uncover important adverse properties of the methodology that relies on homogeneous estimation and testing. More specifically, power functions are low and …