Testing The Purchasing Power Parity Through I (2) Cointegration Techniques

JOURNAL OF APPLIED ECONOMETRICS
J. Appl. Econ. 20: 749– 770 (2005)

Published online 16 June 2005 in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/jae.786
TESTING THE PURCHASING POWER PARITY THROUGH I(2)

COINTEGRATION TECHNIQUES
EMANUELE BACCHIOCCHIa AND LUCA FANELLIb *

a Department of Economics and Business Administration, University of Milan, Italy
b Department of Statistical Sciences, University of Bologna, Italy
SUMMARY
This paper contributes to the empirical literature on the purchasing power parity (PPP) over the post-Bretton
Woods period by providing a time-series based interpretation of the controversial evidence characterizing the
dynamics of real exchange rates. It is shown that the persistence of deviations from the PPP between a set
of European countries and the United States may be empirically attributed to the presence of I(2) stochastic
trends in prices using Consumer Price Indices. Interestingly, the slow adjustment towards the equilibrium can
be modelled through ‘integral-proportional’ equilibrium correction models and this evidence can be partly
reconciled with theories where the inflation rate reduces the markup of profit-maximizing firms acting on
imperfectly competitive markets. Copyright  2005 John Wiley & Sons, Ltd.
1. INTRODUCTION
The purchasing power parity (PPP) is perhaps the most important parity condition of open-economy
macroeconomic models. It states that once converted to a common currency, national price levels
should equalize. From the point of view of policy analysis, in a world where the PPP holds and the
‘pass-through’ from exchange rates to prices is complete, exchange rates act as stabilizing devices,
see e.g. Betts and Devereux (2000). It is commonly agreed that the PPP proposition should hold
in the very long run, i.e. over time spans where all frictions preventing perfect arbitrage in good
prices can be neglected. However, if the PPP receives substantial empirical support over century
spans of data (see e.g. Taylor, 2002 and references cited therein), things are different when the
proposition is investigated over shorter (and perhaps more homogeneous) horizons. It is generally
found, indeed, that the speed of convergence to PPP is much slower than would be expected in
models of short-term stickiness of nominal prices. The empirical investigation of the PPP over the
post-Bretton Woods is controversial and has raised a well-known puzzle of international economics
(see e.g. Rogoff, 1996 and Obstfeld and Rogoff, 2000).
Taylor (2001) identifies temporal aggregation and linear specification issues as possible empirical
explanations of the PPP puzzle. Furthermore, difficulties in measuring real exchange rates should
also be taken into account because of the differences in consumption baskets and price indices
across countries. Another traditional explanation of the persistence of real exchange rates is the
existence of non-tradeable goods even though recent empirical evidence shows that international
divergences in the relative consumer prices can be attributed mainly to tradeables (see, inter alia,
Engle, 1999, 2000).
Ł Correspondence to: Professor Luca Fanelli, Dipartimento di Scienze Statistiche, Universita di Bologna, Via Belle Arti
41, 1-40126 Bologna, Italy. E-mail: fanelli@stat.unibo.it
Copyright  2005 John Wiley & Sons, Ltd. Received 27 November 2001
Revised 9 February 2004
750 E. BACCHIOCCHI AND L. FANELLI
Within the huge literature where the PPP is investigated over the floating period, three major
lines of research can be recognized. In the first approach it is implicitly recognized that, despite
the occurrence of non-zero transaction costs, the PPP proposition holds over medium to long-run
horizons as well; its empirical failure is mainly due to the low power of unit root tests aimed to
establish the mean-reversion property of real exchange rates over relatively small samples. The
increasing use of panel unit root techniques (both in a univariate and multivariate framework)
is intended to gain power by exploiting also the cross-sectional dimension of data, as shown
by Frankel and Rose (1996), MacDonald (1996), Lothian (1997), Papell (1997), among many
others. The second approach is based on the idea that market frictions in international trade
introduce ‘bands of inactions’ within which agents do not arbitrage away deviations from the
PPP since such deviations are not large enough to cover transaction costs in international trade.
In this interpretation adjustment towards the PPP in the post-Bretton Woods era is non-linear
and threshold specifications are employed as in e.g. Michael et al. (1997), Baum et al. (2001)
and Taylor (2001). In the third approach efforts are made to model explicitly departures from
the PPP; real determinants of exchange rates are usually attributed to net foreign assets and
Balassa–Samuelson productivity effects, as suggested by Edison and Klovland (1987) and Rogoff
(1996). On the other hand, focusing on the interaction between goods and capital markets, Juselius
(1995) and Juselius and MacDonald (2000) propose a joint modelling approach where the PPP is
investigated jointly with other international parity conditions such as the uncovered interest-rate
parity (UIP), the term structure of interest rates and the Fisher real interest rate parity. Finally,
increasing attention has been devoted to theories of pricing-to-market (PTM) and local-currency-
pricing (LCP), see, inter alia, Krugman (1987), Rogoff (1996) and Obstfeld and Rogoff (2000). In
this view firms set different prices for their goods across segmented national markets to compete
with the firms serving on those markets; the effect of PTM and LCP is the non-complete exchange
rate ‘pass-through’.
In general, in all quantitative reassessments of the PPP ‘additional’ variables have to be properly
included in the information set comprising nominal exchange rates and price levels in order to
achieve mean-reverting relations.
The idea of the present paper is that insights on the persistence of deviations from the PPP
can be achieved by suitably modelling the time-series properties of prices. In particular, when
price levels are measured in terms of CPIs and to the extent that they can be approximated
as second-order non-stationary integrated processes (I(2)) over the post-Bretton Woods period,
inflation rates are the ‘natural’ candidates to explain the persistence of deviations from the PPP.
The inclusion of the inflation rate in the PPP relation can be justified in our model by appealing
to the theories where firms acting on imperfectly competitive markets face inflation costs which
reduce the markup as in e.g. Russell et al. (1997), Banerjee et al. (2001) and Banerjee and Russell
(2001a,b). Within this interpretation deviations from the PPP can be empirically formulated as
‘polynomially cointegrating’ relations (Granger and Lee, 1989, 1991; Engle and Yoo, 1991; Gregoir
and Laroque, 1994), i.e. as relations where growth rates cointegrate with the levels of variables.1
Theoretically based rationales for augmenting international pricing relations with inflation rates
may also be found in theories aimed at explaining import prices determination. For instance, using
Naug and Nymoen’s (1996) idea, Kongsted (2003) argues that the presence of inflation rates
1 The notion of polynomial cointegration is well suited to describe stock-flow relations but also situations where the
presence of market rigidities and/or adjustment costs gives rise to ‘slowly evolving’ equilibria or dynamic steady states,
see e.g. Haldrup (1998).
Copyright  2005 John Wiley & Sons, Ltd. J. Appl. Econ. 20: 749–770 (2005)
PPP AND I(2) 751
in standard PTM relations for import pricing can be justified as demand pressure terms. Nielsen
(2002) uses similar arguments for export pricing relations. Pedersen (2002) exploits the hypothesis
of (quadratic) adjustment costs and rational expectations to justify the inclusion of inflation rates
in the analysis of the PPP between some metropolitan areas of the United States.
It is common practice in the cointegration literature to eliminate possible I(2) trends in
the variables by suitably transforming the time series at hand with the advantage of applying
‘standard’ I(1) cointegration techniques; an example may be found in Juselius (1995). However, as
shown in Kongsted (2005) and Fiess and MacDonald (2001), not always simple ‘nominal-to-real’
transformations aimed at removing I(2) trends are consistent with data properties. When CPI-based
measures of prices are used, there are at least two reasons for investigating the PPP within a ‘pure’
I(2) model. First, in order to test ‘nominal-to real’ transformations, cointegration techniques for
the original set of I(2) variables should in any case be implemented.2 Moreover, within the I(2)
setup it could happen that relative prices (i.e. the difference between logged domestic and foreign
prices) do not cointegrate to I(1) with coefficients (1, 1), i.e. the hypothesis of long-run price
homogeneity does not hold; in these situations the natural way to investigate the PPP or deviations
from the PPP is to appeal to cointegration techniques for the original set of I(2) variables. Second,
under the I(2) framework the slow dynamic adjustment of exchange rates and prices towards
equilibrium can be modelled through ‘integral-proportional’ equilibrium correction mechanisms,
which prove to be well suited to represent situations where inflation rates reduce the markup of
profit-maximizing firms.
In the empirical investigation of the PPP we focus on three European countries: Germany, the
United Kingdom and France and use monthly data from 1973:01 to 1998:01. The United States
serve as the benchmark reference country and prices are measured in terms of CPIs. Our results
point out that the dynamic pattern of deviations from the PPP over the post-Bretton Woods period
may be in these cases due to the I(2)-type persistence characterizing prices. This evidence may help
to explain why the empirical literature on the existence of unit roots in real exchange rates over
post-Bretton Woods data is so controversial. We find that the estimated polynomially cointegrating
relations may be in part reconciled with a model of departure from the PPP where the markup of
price-setting firms is negatively affected by inflation.
The paper is organized as follows. Section 2 introduces a simple model of deviations from the
LOP. A corresponding model of departure from the PPP is derived. Section 3 summarizes the
different techniques traditionally used to test the PPP hypothesis. It also anticipates part of the
complications which arise within the I(2) framework. Section 4 sketches the statistical model for
the analysis of I(2) cointegrated systems and Section 5 discusses the main empirical scenarios that
might occur in practice when the PPP is investigated through the I(2) model. In Section 6 the I(2)
model is applied to investigate the PPP in three country-pairs over the post-Bretton Woods period.
Section 7 contains some concluding remarks.
2. THE MODEL
Consider two high-income countries, respectively home and foreign. The foreign country is
regarded as the benchmark. We start from the law of one price (LOP), which underlies the PPP
2 Alternatively one could test the presence of I(2) components in the transformed system; in this case, however, I(2)
cointegration techniques should also be implemented in a misspecification testing strategy.
relation. The LOP states that for every good i :

Pit D Et PitŁ 1
where Pit is the domestic currency price of good i at time t, PitŁ is the foreign currency price of
good i at time t and Et is the (bilateral) exchange rate (domestic/foreign) at time t. The parity (1)
hinges on goods market arbitrage, so Pit represents the price of good i at time t that would prevail
if markets were perfectly integrated, i.e. if geography or nationality had no systematic effect on
transaction prices for otherwise identical products, see e.g. Goldberg and Knetter (1997).
It is well recognized, however, that goods markets are not completely integrated and that costs
of various nature drive a wedge between prices in different countries. The behaviour of price-
setting firms can be a further source of departure from (1) as long as commodity arbitrage by
‘third parties’ is ineffective, see e.g. Marston (1990). Consider a price-setting firm which sells the
output for the good i in the domestic and foreign market by maximizing the profit
it D Pit DPit /Pt , Yt C Et PitŁ DŁ PitŁ /PtŁ , YŁt
C[DÐ, Ð C DŁ Ð, Ð, Wt , Pmt ] 2
where it is the profit on good i, DÐ, Ð is the domestic demand for good i with arguments the
ratio of the domestic price of good i over the general price level, Pit /Pt , and real domestic income,
Yt , DŁ Ð, Ð is the foreign demand for good i with arguments the ratio of the foreign price of good
i over the general foreign price level, PitŁ /PtŁ , and real foreign income, YŁt , and finally C[Ð, Ð, Ð] is
firm’s cost function depending, respectively, on the quantities demanded, real (domestic) wages
Wt and the domestic currency price of raw materials Pmt . The first-order conditions associated
with (2) can be written as (see e.g. Marston, 1990)
Pit D C1i Mit 3
Et PitŁ D C1i Nit 4
where C1i D C1 Ð is the marginal cost, Mit D MPit /Pt , Yt is the markup of the domestic price
over marginal costs and Nit D NPitŁ /PtŁ , YŁt is the markup of the foreign price (expressed in
domestic currency) over marginal costs.
The model can be completed by exploiting the ideas set out in Russel et al. (1997), Banerjee
et al. (2001) and Banerjee and Russel (2001a,b). These authors argue that in an uncertain economic
environment higher steady state inflation can reduce firms’ markup over costs. Under different
assumptions on market structure, firms might desire in the long run a constant markup of price
over unit costs net of the cost of inflation.3 Using this hypothesis the quantities Mit and Nit in
(3) and (4) can be specified as
it
M N it
Mit D ; Nit D 5
Pt PtŁ Ł
1C i 1C Ł i
Pt1 Pt1
where M it and N
it are respectively the ‘gross’ markups, Pt /Pt1 and PŁ /PŁ are the
t t1
growth rate of domestic and foreign prices from time t 1 to time t, and i ½ 0 and iŁ ½ 0 are
3 See e.g. Bénabou (1992), Russel et al. (1997) and Athey et al. (2004).
PPP AND I(2) 753
the inflation cost coefficients, i.e. two structural parameters which reflect to what extent domestic
and foreign inflation impose costs by reducing the markup of the risk-averse firm. By substituting
(5) into (3) and (4), taking logs and solving for log Ci1 yields
pit D et C pŁit i pt C Ł Ł

i pt C zit 6
where pit D log Pit , et D log Et , pŁit D log PitŁ , pt D log1 C Pt /Pt1 D logPt /Pt1 ,
pt D log1 C PtŁ /Pt1
Ł Ł
D logPtŁ /Pt1Ł
and zit D log M it log N
it . Equation (6) reads as
a ‘modified LOP’ which incorporates both the domestic and foreign inflation rate with inflation
cost parameters i and iŁ .
Aggregating equation (6) over goods gives rise to
pt D et C pŁt pt C Ł pŁt C zt 7

where D i wi i and Ł D i wi iŁ can be interpreted as ‘averages’
of the is and iŁ s over
goods and thewi s are weights such that 0 wi 1, i wi D 1, i wi pit D pt , i wi pŁit D pŁt .
Finally, zt D i wi zit reads as a weighted average of the difference between the domestic and
foreign ‘gross’ markups. It can be recognized that in (7) the exchange rate ‘pass-through’ is
not complete.
An equivalent representation of equation (7) can be obtained by adding š Ł pt on the right-
hand side and rearranging terms, i.e.
pt D et C pŁt C ωpt C Ł
pŁt pt C zt 8
where the parameter ω D Ł measures the relative importance of the foreign/domestic

inflation cost coefficients. Positive values of ω in (8) imply that the average cost of inflation
experienced by firms in the long run is higher in the foreign market compared to the domestic
one. Adapting the insights in Athey et al. (2004), a positive value of ω in (8) could be attributed
to the effect of greater price competition on the foreign market; they observe that for the case of
colluding price-setting firms, higher inflation and the associated higher variance of cost shocks
makes it more difficult for firms to maintain collusive arrangements, leading to greater competition
and lower markup. More competitive markets can be more costly for risk-averse firms within this
paradigm; positive (negative) values of ω may reflect a more (less) competitive foreign market.
Although (7) and (8) are equivalent formulations of the same model, from the empirical point
of view the two equations are consistent with different empirical scenarios when the possibility
of I(2) stochastic trends in the dynamic system given by et , pŁt and pt is taken into account,
see Section 5. It will be shown that the formulation (8) can be reconciled, under a given set of
conditions, with the presence of a single I(2) stochastic trend in the system generated by et , pŁt and
pt , whereas the formulation (7) can be reconciled with the presence of two I(2) stochastic trends.
3. EMPIRICAL FORMULATION
Let et be the (logged) exchange rate measured as the home currency price of a unit of foreign
currency, pŁt the (logged) foreign price level and pt the (logged) domestic price level. Following
Breuer (1994), the regression equations typically used to test the PPP are specified as
et D ϕ10 ϕ11 pŁt C ϕ12 pt C vt 9

where ϕ1i , i D 0, 1, 2 are regressor coefficients and vt is a residual term. In the cointegration
literature if et , pŁt and pt can be approximated as I(1) processes over the investigated sample, the
quantity vt in (9) should be mean-reverting, or I(0) for the PPP to hold. The ‘absolute’ version of
the PPP hypothesis requires that ϕ10 D 0 and ϕ11 D ϕ12 D 1, implying et C pŁt pt D vt ¾ I0,
where vt can be interpreted as the real exchange rate. It is common practice to distinguish
empirically between ‘strong form’ PPP when et C pŁt pt D vt ¾ I0 and ‘weak form’ PPP
when (9) holds without (or with part of) the above constraints, see Breuer (1994). The restriction
ϕ11 D ϕ12 D 1 in (9) is usually referred to as the ‘proportionality’ hypothesis, whereas ϕ11 D ϕ12
is denoted as the ‘symmetry’ hypothesis. When CPIs are used to measure price levels the
occurrence of ‘weak form’ PPP can be justified as the effect of measurement errors in prices
and the different composition of consumption basket and price indices across countries, see e.g.
Patel (1990) and Rogoff (1996).4 In the following we shall refer to ‘strong form’ PPP when
the proportionality hypothesis holds (regardless of the constant) and ‘weak form’ PPP when
et C ϕ11 pŁt ϕ12 pt D vt ¾ I0 with ϕ11 6D ϕ12 6D 1.
In the last 20 years the empirical investigation of the PPP hypothesis has been traditionally
based on the implementation of: (a1) unit root tests aimed to establish the mean-reversion of real
exchange rates; (a2) cointegration techniques aimed to assess whether a linear combination of the
form (9) is stationary over the selected sample either in the ‘weak’ or ‘strong’ version. In both
(a1) and (a2) nominal exchange rates and price levels are usually modelled as I(1) processes.
When the possibility of I(2) components in price levels is recognized it is more or less implicitly
assumed that the price differential cointegrates to I(1) with coefficients 1, 1 (long-run price
homogeneity).
The empirical evidence based on (a1) and (a2) highlights that the dynamics of adjustment
towards the PPP are much slower than would be expected in a model of short to medium-term
stickiness of nominal prices. Several explanations have been proposed. For instance, following the
Balassa–Samuelson hypothesis, Edison and Klovland (1987) propose a simple general-equilibrium
model of long-run exchange rate determination where the PPP is replaced by an equilibrium relation
of the form
et C pŁt pt C 0 ut ¾ I0
with ut representing a vector containing real factors affecting the trade balance, such as productivity
and taste differentials and terms of trade. On the other hand, Johansen and Juselius (1992), Juselius
(1995) and Juselius and MacDonald (2000) propose a cointegration approach where the PPP is
investigated jointly with other international parity conditions such as the UIP, the term structure
of interest rates and the Fisher real interest rate parity. Here the idea is that after the abolition
of capital controls, movements in capital markets play a relevant role in the determination of
exchange rates.
The key point of the present paper is that I(2)-ness in price measures may be relevant in the
empirical analysis of the PPP over the post-Bretton Woods period and may help to explain the
slow adjustment of exchange rates and prices towards the equilibrium. Moreover, given a set of
conditions we discuss in the next sections, deviations from the PPP within the I(2) model can be
reconciled with the theoretical setup outlined in Section 2.
4 Juselius (1995) observes that the empirical motivation for CPI series within the PPP context is that official measurements
of price inflation are usually calculated from these indices.
PPP AND I(2) 755
Figure 1. Price levels at a monthly frequency in Germany, the UK and France with corresponding growth rates
over the 1973:01–1998:01 period. Price levels are computed by logging domestic CPIs (base year D 1975)
Figure 1 plots CPI-based price levels and the corresponding first differences of Germany, the
United Kingdom and France. Data are monthly and cover the 1973:01–1998:01 period. A simple
graphical inspection suggests that if inflation rates can be regarded as I(1) time series, the idea
that price levels can be approximated as I(2) cannot be a priori rejected. Figure 2 plots price
differentials (all with respect to the United States) for the three countries with corresponding first
differences; also in this case the graphical inspection suggests that the persistence of relative prices
exhibits signs of I(2)-ness.
The theoretical equation (7) and its equivalent reparameterization (8) have been derived by
aggregating the ‘modified LOP’ (6) over goods under the hypothesis that the two countries
have identical baskets of goods; this assumption is rather restrictive in practice. The empirical
counterpart of (8) should be specified to account for possible differences in the composition of
price indices in the two countries. For instance, an estimable version of (8) can be formulated as
Q
et C ϕ11 pŁt ϕ12 pt C υp Ł
t C pt pt D v
Qt 10
where the coefficients ϕ1j , j D 1, 2 are unrestricted a priori, D ϕ12 /ϕ11 and vQ t captures all
remaining factors, including those in zt , affecting the link among exchange rates and relative
prices. Focusing more explicitly on the time series properties of variables, assume that: (i) et can
be approximated as an I(1) process; (ii) pt and pŁt can be approximated as I(2) processes and the
linear combination pŁt pt is I(1) (so that pŁt pt is I(0)); (iii) vQ t is I(0). Then (10) reads
as a polynomial cointegrating relation, i.e. as a cointegrating relation involving both levels and
Figure 2. CPI differentials (relative to the USA) and corresponding first differences over the 1973:01–1998:01
period
first differences of variables (see e.g. Granger and Lee, 1989, 1991; Engle and Yoo, 1991). Under
(i)–(iii), the validity of the proportionality hypothesis ϕ11 D ϕ12 D 1 (implying D 1) ensures full
consistency among the structure of (10) and (8), therefore the parameter υQ can be regarded as the
empirical counterpart of the inflation cost differential ω D Ł .
We shall turn to the interpretation of the polynomially cointegrating relation (10) as a model of
departure from the PPP in Section 5, where we discuss in detail a range of possible scenarios that
may occur in practice within the I(2) framework.
4. STATISTICAL MODEL
In this section we briefly introduce the reference statistical model used in the analysis that follows.
It is assumed that the data generating process for the p-dimensional vector Xt belongs to the class
of vector-equilibrium correction models (VEqCMs) of the form
2 Xt D Xt1 C Xt1 C Ut1 C µ C εt 11
where ,  and  D 1 , 2 , . . . , k2 are matrices of parameters, µ is a p ð 1 constant,

Ut1 D 2 X0t1 , 2 X0t2 , . . . , 2 X0tkC2 0 , k is the lag length and εt is a white noise Gaussian
process with covariance matrix . By assuming that the roots of the characteristic polynomial
associated with (11) are outside the unit circle or equal to one, the I(2) cointegrated system is
PPP AND I(2) 757
obtained under the restrictions (see e.g. Johansen, 1992, 1995)
 D ˛ˇ0 ; ˛0? ˇ? D 0 12
where ˛ and ˇ are p ð r matrices of full rank r (r < p), r is the cointegration rank of the system,
˛? and ˇ? are p ð p r bases of the orthogonal complements of ˛ and ˇ˛0? ˛ D 0, ˇ? 0
ˇ D 0,
and and are p r ð s matrices of full rank such that s < p r. The I(2) cointegrated model
(11)–(12) subsumes the following I(0), I(1) and I(2) quantities:
ˇ0 Xt C υˇ20 Xt ¾ I0, rð1 13

ˇ10 Xt ¾ I1, sð1 14
ˇ20 Xt ¾ I2, p r s ð 1 15
where ˇ2 D ˇ? ? has dimensions p ð p r s, υ D ˛0 ˇ2 has dimensions r ð p r s

and ˇ1 D ˇ? is p ð s, where a D aa0 a1 for a generic full column-rank matrix a. The r linear
combinations in (13) represent the polynomially cointegrating relations of the system and (14) and
(15) are the non-stationary directions, see Johansen (1992, 1995, 1997) for details.
Henceforth r, s and p r s will be referred to as the ‘integration indices’ of the system.
Notice that given ˛, ˇ and any identified versions of ˇ2 ,5 the polynomial cointegration relations
(13) can be alternatively expressed in the form
Q 0 Xt ¾ I0
ˇ0 Xt C υg 16
where υQ D υˇ20 ˇ2 g0 ˇ2 1 and g is a known p ð p r s matrix such that g0 ˇ2 has full rank
(see e.g. Johansen, 1992; Rahbek et al., 1999). The advantage of the representation (16) is that
the g matrix selects the variables in first differences that are required to enter the polynomial
cointegration relations. The formulation (16) will be exploited in the next two sections.
The structure of dynamic adjustment embodied by the I(2) model proves to be more complex
with respect to the I(1) case. Indeed using (16) the system (11)–(12) can be given the following
‘integral-proportional’ equilibrium correction representation
2 Xt D ˛[ˇ0 Xt1 C υg
Q 0 Xt1 ]
C 1Ł ˇ0 Xt1 C 2Ł ˇ10 Xt1 C Ut1 C µ C εt 17
where 1Ł D 1 ˛υgQ 0 ˇ, 2Ł D 2 ˛υg

Q 0 ˇ1 , 1 D ˇ and 2 D ˇ1 .6 We refer to Johansen (1992,
1995, 1997), Paruolo (1996, 2000), Rahbek et al. (1999) and Paruolo and Rahbek (1999) for
details on the inferential issues regarding the I(2) cointegrated model.
5. TESTING DEVIATIONS FROM THE PPP: POSSIBLE SCENARIOS

Modelling Xt D et , pŁt , pt 0 as in (17) is consistent with different departure schemes from the
PPP, depending on the values assumed by r and s. Moreover, the structure of dynamic adjustment
5 Seee.g. Paruolo and Rahbek (1999, p. 285) for details.

6 Therepresentation (17) is obtained from the equation (2.11) in Paruolo and Rahbek (1999) by using υQ D υˇ20 ˇ2 g0 ˇ2 1
and some algebra.
implied by (17) may help to explain the slow convergence of exchange rates and prices to the
PPP during the post-Bretton Woods period. In this section we discuss a set of ‘admissible’ ranges
of values of r and s that might occur in practice when the PPP is investigated within the I(2)
framework. We also discuss the corresponding structure of polynomial cointegration relations and
highlight the conditions under which these relations can be reconciled with the implication of the
model outlined in Section 2.
The main empirical scenarios are collected below from A to E.
(A) p r s D 0. Whatever r and s the model (17) reduces to an I(1) system. The PPP hypothesis
can be analysed through I(1) cointegration techniques.
(B) r D 2 and s D 0. Here Xt D et , pŁt , pt 0 is driven by an I(2) stochastic trend p r s D 1
and two I(0) relations. In this case a possible specification of the polynomial cointegration
relations (16) is given by:
Q
1 0 0 et υ11 et
Ł Q 0 0 1
0 1 pt C υ21 0 pŁt
0 g
ˇ pt υQ pt

et C υQ 11 pt
D ¾ I0 18
pŁt pt C υQ 21 pt
Here the two prices are assumed to be I(2) and cointegrate to I(1) with coefficients 1, ,
whereas the nominal exchange rate is I(1). A suitable linear combination of the two cointe-
grating vectors in (18) can be interpreted as the polynomially cointegrating relation we discuss
in scenario C below. The constraint D 1 in (18) can be reconciled with long run price
homogeneity.
(C) r D 1 and s D 1. Here Xt D et , pŁt , pt 0 is driven by an I(1) stochastic trend s D 1, an I(2)
stochastic trend p r s D 1 and a single I(0) relation. Assuming that the I(2) stochastic
trend involves the two prices, the polynomial cointegration relation (16) can be specified as

et Q et
1 ϕ11 ϕ12 υ 0 0 1
pŁt C pŁt
ˇ0 1ð1 g0
pt pt
Ł
D et C ϕ11 p ϕ12 pt C υpt ¾ I0 19
t
Under this scenario the I(0) quantity pŁt pt , with D ϕ12 /ϕ11 , is embedded in the
ˇ0 Xt1 term of (17), hence the polynomial cointegration relation (10) subject to the conditions
(i)–(iii) of Section 3 and the polynomial cointegration relation (19) are equivalent in the sense
that a linear combination of et , pŁt , pt and pt is sufficient to generate a stationary process.7
A crucial point within this scenario is the interpretation of the υ parameter in (19). Consider
first the ‘benchmark’ situation where ‘strong form’ PPP holds in (19). If ϕ11 D 1 D ϕ12
(implying ˇ0 D ˇ00 D 1, 1, 1), then equation (19) corresponds to the formulation (8) of the
theoretical model introduced in Section 2. This means that υ in (19) can be regarded as the
7 It is worth noting that if in this scenario the hypothesis of symmetry ϕ D ϕ

11 12 holds, the estimation of the model
can be based on the I(1) ‘transformed’ system Yt D et , pŁt pt , pt 0 without loss of relevant information, see e.g.
Kongsted (2003, 2005). Nevertheless, if ϕ11 6D ϕ12 , Yt D et , pŁt pt , pt 0 would retain the I(2) component and the
‘natural’ approach for estimating (19) would be to consider the ‘original’ system of I(2) variables.
PPP AND I(2) 759
counterpart of the inflation cost differential ω D Ł of equation (8); positive estimates

of υ reflect a situation where the inflation cost experienced by firms on the foreign market is
higher than the inflation cost experienced on the domestic market. The opposite interpretation
holds for negative estimates of υ.
However, when ˇ in (19) deviates from the ‘benchmark’ case, i.e. when ˇ0 6D ˇ00 D
1, 1, 1, there is not a full correspondence among the structure of the polynomially
cointegrating relation (19) and equation (8), hence the interpretation of υ requires more caution.
To see this observe that in the I(2) model of Section 4, the υ matrix in (13) depends on the
I(2) directions ˇ2 and hence on ˇ since ˇ2 and ˇ are orthogonal by construction. In turn υ
depends on ˇ2 υ D υˇ20 ˇ2 g0 ˇ2 1 , therefore the estimates of υ are indirectly sensitive to ˇ.
In general one has to expect the magnitude of estimated υs in (19) to be sensitive to the degree
of departure of ˇ from ˇ00 D 1, 1, 1; this is exactly what we find empirically in Section 6.
(D) r D 1 and s D 0. Here Xt D et , pŁt , pt 0 is driven by two I(2) stochastic trends p r s D 2
and a single I(0) relation. Two (sub)scenarios are relevant within this configuration of
integration indices. First, let us rule out a priori the possibility that the nominal exchange
rate can be an I(2) process.8 Hence et is approximated I(1) and the two price levels I(2); since
there are two I(2) trends in the system the two prices do not cointegrate to I(1). A possible
specification of (16) is the following:

et 0 1 0 et
1 0 0
pŁt C υ1 , υ2 0 0 1 pŁt
ˇ0 0
pt g pt
Ł
D et C υ1 p C υ2 pt ¾ I0 20
t
i.e. a cointegration relation involving the nominal exchange rate and the two inflation rates. It
can be recognized that differently from the scenarios B and C above, the relation (20) cannot
be reconciled with the structure of equation (8). However, if υ1 > 0 and υ2 < 0 the structure
of (20) suggests a ‘modified’ PPP relation. Second, assume that an I(2) stochastic trend drives
also the nominal exchange rate. In this circumstance the polynomial cointegration relation
(16) is specified as

et 0 1 0 et
1, ϕ11 , ϕ12
pŁt C υ1 , υ2 0 0 1 pŁt
ˇ0 0
pt g pt
D et C ϕ11 pŁ ϕ12 pt C υ1 pŁ C υ2 pt ¾ I0
t t 21
so that prices and the nominal exchange rate are, using standard notation, CI(2, 1). It is clear
that in the presence of ‘strong form’ PPP ˇ0 D ˇ00 D 1, 1, 1 the relation (21) reads as
the empirical counterpart of the theoretical equation (7) if υ1 > 0 and υ2 < 0, with υ1 and υ2
playing respectively the role of the foreign and domestic inflation cost parameters Ł and .
In order to disentangle among (20) and (21) within this scenario it is sufficient to test whether
the structure ˇ0 D 1, 0, 0 is rejected or not by the data.
8 The choice of not considering the hypothesis e ¾ I2 eliminates some combinations of integration indices (r, s) from
t
the set of admissible values. For instance, the combination r, s D 0, 0 would imply p r s D 3 I(2) stochastic trends
in Xt and hence an I(2) component in the nominal exchange rate.
(E) r D 0 and s D 1. In this situation Xt D et , pŁt , pt 0 is driven by two I(2) stochastic trends
p r s D 2 and one I(1) stochastic trend. Since levels and first differences do not
cointegrate, it is not possible to identify a relation consistent with (7) or (8). However, in
the light of (17) the adjustment of 2 Xt will occur with respect to growth rate relations.
In summary, in the I(2) cointegrated model the occurrence of the scenarios B, C and part of D
can somehow be reconciled, under the conditions stated above, with the model of departure from
the PPP outlined in Section 2.
6. RESULTS
In this section we apply the cointegrated model for I(2) processes introduced in Section 4 to
investigate the PPP for three country-pairs: Germany/United States, United Kingdom/United States
and France/United States.
The source of the data is Datastream and all exchange rates are expressed in terms of domestic
currency relative to the US dollar. Prices are measured in terms of seasonally unadjusted CPIs
with the same base year 1975. We consider monthly (seasonally unadjusted) data from 1973:01
to 1998:01 for a total of T D 300 monthly observations. The three graphs of Figure 3 compare
on the same scale the nominal exchange rates of the three countries with corresponding relative
prices (domestic/US).
A simple graphical inspection of Figure 3 shows that for the case of France/USA the dynamic
pattern of the price differential pt pŁt closely mirrors that of the nominal exchange rate et over
Figure 3. Logged nominal exchange rates and price differentials (on the same scale) over the 1973:01–1998:01
period
PPP AND I(2) 761
the sample period. The co-movement among et and pt pŁt is also evident for the UK/USA
country-pair, though less clear-cut, and is less evident for the Germany/USA pair, especially during
the 1980–1985 period. The graphics anticipate that differences have to be expected in the empirical
analysis for the three country-pairs.
For each country-pair we estimated by maximum likelihood a VAR of the form (11) with
Xt D et , pŁt , pt 0 . The calculations were performed in PcGive 10.0, see Doornik and Hendry
(2001). In each VAR we included a set of deterministic (centred) seasonal dummies and a set
of intervention dummies to capture the extraordinary episodes characterizing commodity and
exchange rate markets during the sample period.9 The lag length of each VAR was chosen following
a ‘general-to-specific’ approach by starting with the estimation of a model with k D 9 lags and
testing sequentially for possible lag reduction and the mean innovation property of disturbances
against the available information set. We selected k D 2 lags in the VARs for Germany/USA and
UK/USA and k D 7 lags in the VAR for France/USA.
After fixing the values of k we first tested the cointegration rank of the system as in the I(1)
case by computing the LR Johansen’s trace statistic (Qr in the tables). Secondly we estimated
the I(2) model through the two-step algorithm (2SI2) originally proposed by Johansen (1995) and
computed the test for integration indices r, s, p r s (Sr,s in the tables).10 The constant µ was
restricted to rule out the presence of deterministic quadratic trends in the data (see Paruolo, 1996).
Results are reported in Tables I–III. According to the discussion of Section 5, the test statistic Sr,s
allows us to disentangle among different empirical scenarios.
The sequential testing procedure for selecting the integration indices through Sr,s starts with the
most restricted model, r, s D 0, 0, in the upper left-hand corner of the table, continues to the
end of the first row and proceeds row-wise from left to right until the first acceptance. Results
suggest that I(2) components seem to characterize the three specified systems. In particular, the test
selects the scenario C for all three country-pairs (i.e. a single I(2) stochastic trend in the system),
confirming the presence of I(2) components in the data and the occurrence of a polynomially
cointegrating relation of the form (19).
The summary of estimation results may be found in Tables IV and V where, after imposing the
I(2) constraints on the VARs, we reported the estimated parameters of the equilibrium correction
system (17) except the short-run parameters in  and coefficients associated with deterministic
variables. Starting from the top, the two tables report: (a) the chosen VAR’s lag length k ; (b) the
value of the cointegration rank selected in the I(1) model; (c) the values of the integration
indices r, s selected in the I(2) model; (d) the (just-identified) estimated cointegration relations
0 Xt D et C ϕ
ˇ 11 pŁt ϕ 12 pt ; (e) the LR tests for the hypothesis of symmetry ϕ11 D ϕ12 ; (f) the
LR test for the hypothesis of proportionality ϕ11 D ϕ12 D 1; (g) an LR test for possible additional
9 The dummies are denoted by Dyymm , with ‘yy’ representing the year and ‘mm’ the corresponding month. They
t
assume value 1 when t D t0 D yy : mm, 1 when t D t0 C 1 and zero elsewhere, hence broken trends are ruled out
from the vector moving average representation of the I(2) cointegrated VAR (see e.g. Johansen, 1992, 1995). The
dummies included in the VAR for Germany/USA are: D7308t , D8603t and D9001t ; those included in the VAR
for UK/USA are: D7308t , D7907t , D8001t , D9001t and D9210t ; those included in the VAR for France/USA are:
D7308t , D8001t , D8701t , D9001t and D9103t . For instance, D7308t (which enters all estimated VARs) takes value 1
at 1973:08, 1 at 1973:09 and zero elsewhere; it accounts for the tensions which characterized the oil market in August
1973 with marked effects on the US inflation rate. The remaining dummies are defined similarly in correspondence
of analogous episodes. We found that the inclusion of such dummies improved in several cases the autocorrelation of
residuals but not their non-normality and in particular their skewness. Moreover, estimates do not change dramatically by
not including the intervention dummies in the analysis.
10 The 2SI2 procedure provides asymptotically efficient estimates, see Paruolo (2000). The 2SI2 procedure was imple-
mented in Gauss 3.01.
Table I. Upper panel: LR trace test for cointegration rank in the I(1) model;
5% asymptotic critical values in brackets, see Johansen (1996). Lower panel:
2SI2 test for integration indices r and s in the I(2) model; 5% asymptotic
critical values in brackets, see Paruolo (1996). The lag length of the VAR is
k D 2; the model includes centred seasonal dummies and a set of dummies as
detailed in footnote 9 of the text
Germany/USA
rj 0 1 2
Qr 48.2 4.8 0.7
29.7 15.4 3.8
pr r Sr,s
3 0 421.9 228.4 83.2 48.2
70.9 51.4 38.8 29.7
2 1 174.4 10.6 4.8
36.1 22.6 15.4
1 2 53.7 0.7
12.9 3.8
prs 3 2 1 0
Table II. Upper panel: LR trace test for cointegration rank in the I(1) model;
UK/USA
rj 0 1 2
Qr 58.1 12.1 2.9
29.7 15.4 3.8
pr r Sr,s
3 0 369.8 190.0 80.3 58.1
70.9 51.4 38.8 29.7
2 1 128.0 18.7 12.1
36.1 22.6 15.4
1 2 26.4 2.9
12.9 3.8
prs 3 2 1 0
hypotheses on the structure of cointegrating relations; (h) the restricted ˇ 0 Xt relation; (i) the
estimated ˇ 0 Xt term (when s 6D 0) obtained after fixing ˇ as in (h); (j) the estimated polynomial
1
cointegration relation (19) with ˇ fixed as in (h); (k)–(l)–(m) the estimated matrices of adjustment
coefficients ˛,
1Ł and
2Ł of system (17), with associated standard errors.
The estimated cointegrating relations ˇ 0 Xt and polynomial cointegrating relations ˇ0 Xt C υˇ0 Xt
2
in the unrestricted form (13) are plotted in Figure 4; this graph stresses the importance of growth
rates in explaining deviations from the PPP.
It can be noticed from row (d) of Tables IV and V that the signs of the unrestricted ˇ coefficients
are consistent with a priori expectations for UK/USA and France/USA but not for Germany/USA
PPP AND I(2) 763
Table III. Upper panel: LR trace test for cointegration rank in the I(1) model;
France/USA
rj 0 1 2
Qr 40.7 18.6 2.1
29.7 15.4 3.8
pr r Sr,s
3 0 122.8 61.7 43.4 40.7
70.9 51.4 38.8 29.7
2 1 36.3 21.0 18.6
36.1 22.6 15.4
1 2 12.9 2.1
12.9 3.8
prs 3 2 1 0
where the PPP does not seem to receive support. From rows (e) and (f) it follows that ‘strong form’
PPP holds for France/USA ˇ0 D 1, 1, 1, ‘weak form’ PPP for UK/USA ˇ 0 D 1, 1, 0.45
and a relation with ‘wrong’ coefficient signs (and unbalanced magnitudes) for Germany/USA
0 D 1, 1.13, 4.10.
ˇ
Focusing on the whole structure of estimated polynomial cointegrating relations (19), we find
a positive sign of υ for all three country-pairs, with a magnitude which seems to be directly

proportional to the degree of departure of ˇ from ‘strong form’ PPP (υ D 7.3 for France/USA;

υ D 66.7 for UK/USA; υ D 384.4 for Germany/USA), see row (j) of Tables IV and V.11 This
finding confirms empirically the insights of Section 5, scenario C, about the (indirect) sensitivity
of υ to ˇ.
Throughout we discuss separately the results concerning the three country-pairs.
France/USA
We find ‘strong form’ PPP in the ˇ vector of (19), thus as detailed in Section 5, scenario C, we
can regard the estimated polynomially cointegrating relation (row (j), Table V) as the empirical

counterpart of the theoretical equation (8). This means that υ D 7.28 can be interpreted as an
estimate of the inflation cost differential ω D Ł . As explained in Section 2, the positive

sign of υ suggests that the average long-run cost of inflation for French firms has been higher on
the US market.
The estimated adjustment coefficients ˛, 1Ł and 2Ł of the ‘integral-proportional’ equilibrium
correction system (17) (rows (k)–(l)–(m), Table V) show that the nominal exchange rate adjusts
11 Notice that the domestic inflation rate in the estimated polynomial cointegration relations of Tables IV and V is not
expressed in annualized percentage terms; this means that one could divide the estimated υs for the scale factor 12 ð 100

(obtaining respectively υ D 0.0061 for France/USA; υ D 0.056 for UK/USA; υ D 0.32 for Germany/USA).
Table IV. 2SI2 estimates of the parameters of the equilibrium correction

system (17) over the 1973:01–1998:01 period (standard errors in brack-
ets). The model includes centred seasonal dummies and a set of dummies
as detailed in footnote 9 of the text
Germany/USA
(a) lags k 2
(b) selected r 1
I(1) model
(c) selected (r, s) (1, 1)
I(2) model
(d) 0 Xt
unr. ˇ et 1.13 pŁt C 4.10 pt
0 D 1, ϕ
ˇ 11 , ϕ
12 0.90 1.57
(e) LR for symmetry 2 1 D 17.0 p-value D 0.00

H0 : ˇ0 D 1, ϕ11 , ϕ11
(f) LR for proportionality 2 2 D 35.5 p-value D 0.00

H0 : ˇ0 D 1, 1, 1
(g) LR for other hypotheses H0 : ˇ0 D 0, 1, a
2 1 D 11.9 p-value D 0.00
(h) 0 Xt
restr. ˇ et 1.13 pŁt C 4.10 pt
0.90 1.57
(i) 0 Xt
unr. ˇ et C 0.71pŁt 0.05pt
1
0 Q
(j) ˇ Xt C υp t et 1.13pŁt C 4.10pt C 384.4pt
 0.00098 
 0.0068 
(k)
˛  0.0024 
ˇ0 Xt1 C
Q t1
υp  0.0004 
0.0017
0.0005
 0.26 
 0.18 
(l)
Ł 0  0.26 
1ˇ Xt1  0.01 
0.08
0.03

1.16 
 0.19 
(m)
Ł  0.25 
2
ˇ10 Xt1  0.01 
0.06
0.03
to all I(0) equilibrium relations. Equation (8) is actually specified as a pricing relation, hence one
would also expect prices to adjust to the equilibria relations subsumed by (17). Table V shows that
prices adjust significantly, though at a slower rate with respect to the exchange rate, as expected.
UK/USA
We find ‘weak form’ PPP in the ˇ vector of (19), i.e. a cointegrating vector with the struc-
ture ˇ0 D 1, 1, a and a 6D 1. The symmetry hypothesis is marginally rejected p-value D
0.03 but if we impose it (i.e. if we estimate a vector of the form ˇ0 D 1, ϕ11 , ϕ11 ) the
11 < 0). This evidence suggests
sign of estimated parameters is not correct (i.e. we obtain ϕ
that contrary to what happens for the case of France/USA, the analysis of PPP between
PPP AND I(2) 765
Table V. 2SI2 estimates of the parameters of the equilibrium correction system (17) over the 1973:1–1998:1
period (standard errors in brackets). Each estimated model includes centred seasonal dummies and a set of
dummies as detailed in footnote 9 of the text
UK/USA France/USA
(a) lags k 2 7
(b) selected r 1 2
I(1) model
(c) selected r, s (1, 1) (1, 1)
I(2) model
(d) 0 Xt
unr. ˇ et C 0.95 pŁt 0.42 pt et C 0.78 pŁt 1.22 pt
0 D 1, ϕ
ˇ 11 , ϕ
12 0.76 0.53 0.79 0.66
(e) LR for symmetry 2 1 D 4.5 p-value D 0.03 2 1 D 1.5 p-value D 0.21
H0 : ˇ0 D 1, ϕ11 , ϕ11
(f) LR for proportionality 2 2 D 37.49 p-value D 0.00 2 2 D 3.0 p-value D 0.22
H0 : ˇ0 D 1, 1, 1
(g) LR for other hypotheses H0 : ˇ0 D 1, 1, ϕ12 —
2 1 D 0.0035 p-value D 0.95
(h) 0 Xt
restr. ˇ et C pŁt 0.45 pt et C pŁt pt
0.07
(i) unr. ˇ 0 Xt et 0.75pŁt C 0.55pt et 0.76pŁt C 0.24pt

1
(j) 0 Xt C
ˇ Q t
υp et C pŁt 0.45pt C 66.7pt et C pŁt pt C 7.28pt
 0.0298   0.0497 
 0.01   0.0153 
(k)
˛  0.0025   0.0024 
ˇ0 Xt1 C
Q t1
υp  0.0006   0.0009 
0.0049 0.0001
0.0013 0.0009
 1.71   3.07 
 0.30   0.67 
(l)
Ł 0  0.24   0.23 
1ˇ Xt1  0.02   0.04 
0.17 0.13
0.04 0.04
 0.83   2.33 
 0.30   0.64 
(m)
Ł  0.24   0.23 
2
ˇ10 Xt1  0.02   0.04 
0.16 0.12
0.04 0.04
the United Kingdom and the United States should not be based on the transformed sys-
tem Yt D et , pŁt pt , pt 0 which might retain an I(2) component. We provide two com-
bined explanations for the occurrence of ‘weak form’ PPP. First, as explained in Section 3,
baskets of goods as well as the portion of tradeable/non-tradeable goods within such bas-
kets can be different even across very similar countries, leading to the violation of symme-
try and proportionality, specially when CPIs are used. Second, it can be noticed from the
graph of Figure 3 that despite et and pt pŁt seem to co-move over the whole post-Bretton
Woods period, their dynamics over the 1980–1985 subperiod are not as synchronized as for
the France/USA case. The effects of the prolonged dollar appreciation during the 1980–1985
period might well explain the rejection of the symmetry and proportionality hypotheses (see
also below).
The estimated υ in (19) is still positive (row (j), Table V). Given the violation of the proportion-
ality hypothesis, in this case there is not a full correspondence among the estimated polynomially
0 Xt (left-panel) and unrestricted polynomial cointegration relation

Figure 4. Estimated cointegration relation ˇ
0 0
ˇ Xt C υˇ2 Xt (right-panel) for Germany/USA, UK/USA and France/USA (1973:01–1998:01)
cointegrating relation and the structure of equation (8) (see the discussion of Section 5, scenario

C). The departure of ˇ from ‘strong form’ PPP affects the magnitude of the estimated υυ D 66.74

which is relatively higher than the υ estimated for France/USA. In this case υ has to be regarded
as a rough estimate of the inflation cost differential ω, however, it has the same sign as for the
France/USA case.
PPP AND I(2) 767
The nominal exchange rate as well as prices adjust significantly to the equilibria relations of
system (17), as suggested by the estimated ˛, 1Ł and 2Ł (rows (k)–(l)–(m), Table V). Also in this
case prices adjust at a slower rate with respect to the exchange rate.
Germany/USA
The PPP does not receive empirical support in the sense that the estimated ˇ vector in (19) displays
wrong signs and unbalanced magnitudes. We tested the validity of a cointegrating relation of the
form ˇ0 D 0, 1, a a 6D 1, i.e. a relation involving the two prices only, rejecting the hypothesis
(row (g), Table IV). The violation of the PPP among Germany and the United States over the
post-Bretton Woods period is a common finding in the literature (see e.g. Baum et al., 2001 where
a slightly shorter sample is used with similar data) and supports the intuition provided by the
graphs of Figures 2, 3 and 5. The sharp appreciation of the US dollar during the 1980–1985
period combined with the tight Bundesbank anti-inflationary policy of those years are possible
explanations of the ‘wrong’ estimated signs of ˇ over the whole post-Bretton Woods period.12
In fact, in correspondence with the depreciation of the D-mark during this period, Germany
experienced a decrease of its inflation rate relative to the USA; Juselius and MacDonald (2000)
provide detailed explanations of the reasons underlying such a break. Interest rates capturing the
effects of movements in capital markets should probably be included in the data set to explain the
failure of the PPP for Germany/USA, see e.g. Juselius (1995) and Juselius and MacDonald (2000).
In this case it is not possible to reconcile the structure of the estimated polynomial cointegrating
relation (19) with the implications of equation (8). This fact is also reflected in the magnitude of

the estimated υυ D 384.4, which appears extremely high compared to the previous two cases.
As concerns the short-run adjustment to the equilibria, the estimated ˛s (row (k), Table IV)
show that the nominal exchange rate does not adjust, as expected, to the estimated polynomial
Figure 5. Cross-plots of pt pŁt (x-axis) and et (y-axis) over the 1973:01–1998:01 period for Germany/USA
12 Common wisdom contends that the prolonged dollar appreciation following the ‘Reagan Experiment’ was probably due
to a speculative bubble unrelated to economic fundamentals. In this regard Lothian (1997) observes that the behaviour of
the US dollar during the 1980– 1985 period is likely to affect any test of PPP over the post-Bretton Woods era when the
US dollar is used as numeraire.
cointegrating relation. On the other hand, prices adjust significantly to the stationary relations
implied by the equilibrium correction system (17) (rows (k)–(l)–(m), Table IV).
7. CONCLUSIONS
In this paper we have provided a simple model of departures from PPP which can be empirically
formulated as a polynomial cointegration relation and reconciled with the I(2)-type persistence
observed in CPI-based measures of price levels. Under precise conditions, deviations from the
PPP can be explained by appealing to theories where the markup over costs of firms operating
on imperfectly competitive markets is negatively affected by the inflation rate. Within the I(2)
setup the specification of the dynamic adjustment towards the PPP requires ‘integral-proportional’
equilibrium correction models, which prove to be well suited to describe the slow convergence to
equilibrium of both exchange rates and prices.
Using the United States as the benchmark country and multivariate cointegration techniques,
our results on Germany, the United Kingdom and France show that I(2) stochastic trends seem to
characterize CPI-measured price levels over the post-Bretton Woods period. This result suggests
that ‘additional’ variables such as the inflation rate (or variables sharing the same stochastic trend)
are required to explain the persistence of real exchange rates or linear combinations of et , pŁt
and pt . ‘Strong form’ PPP is found to hold only for the France/USA country-pair where it is
possible to fully reconcile empirical results with the implications of the theory. For the UK/USA
pair the PPP holds in ‘weak form’ and the empirical evidence can partly be reconciled with the
implications of the theory. Finally, for the Germany/USA country-pair the PPP does not seem to
hold at all, confirming the finding of previous studies.
Overall our evidence points to the fact that the common practice of applying unit root techniques
to real exchange rates to test the PPP can be misleading when CPIs are used.
ACKNOWLEDGEMENTS
We would like to thank two referees, Giuseppe Cavaliere, Attilio Gardini, Roberto Golinelli,
Gianmarco Ottaviani, Paolo Paruolo and participants to the 2001 European Meeting of the
Econometric Society (Lousanne) for useful comments on previous versions of the paper. Special
thanks are due to Paolo Paruolo for providing us with his Gauss 3.01 code for the 2SI2 procedure.
We are solely responsible for all errors. The first author acknowledges financial support from Italian
“Giovani Ricercatori” grant. The second author acknowledges financial support from Italian MIUR
ex 60% and “Giovani Ricercatori” grants.
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Testing The Purchasing Power Parity Through I (2) Cointegration Techniques

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JOURNAL OF APPLIED ECONOMETRICS

J. Appl. Econ. 20: 749– 770 (2005)

TESTING THE PURCHASING POWER PARITY THROUGH I(2)

EMANUELE BACCHIOCCHIa AND LUCA FANELLIb *

relation. The LOP states that for every good i :

pit D et C pŁit i pt C Ł Ł

pt D et C pŁt pt C Ł pŁt C zt 7

where the parameter ω D Ł measures the relative importance of the foreign/domestic

et D ϕ10 ϕ11 pŁt C ϕ12 pt C vt 9

2 Xt D Xt1 C Xt1 C Ut1 C µ C εt 11

where ,  and  D 1 , 2 , . . . , k2 are matrices of parameters, µ is a p ð 1 constant,

obtained under the restrictions (see e.g. Johansen, 1992, 1995)

 D ˛ˇ0 ; ˛0? ˇ? D 0 12

ˇ0 Xt C υˇ20 Xt ¾ I0, rð1 13

where ˇ2 D ˇ? ? has dimensions p ð p r s, υ D ˛0 ˇ2 has dimensions r ð p r s

where 1Ł D 1 ˛υgQ 0 ˇ, 2Ł D 2 ˛υg

5. TESTING DEVIATIONS FROM THE PPP: POSSIBLE SCENARIOS

5 Seee.g. Paruolo and Rahbek (1999, p. 285) for details.

7 It is worth noting that if in this scenario the hypothesis of symmetry ϕ D ϕ

counterpart of the inflation cost differential ω D Ł of equation (8); positive estimates

Table IV. 2SI2 estimates of the parameters of the equilibrium correction

(e) LR for symmetry  2 1 D 17.0 p-value D 0.00

(f) LR for proportionality  2 2 D 35.5 p-value D 0.00

(i) unr. ˇ 0 Xt et 0.75pŁt C 0.55pt et 0.76pŁt C 0.24pt

0 Xt (left-panel) and unrestricted polynomial cointegration relation

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 D ˛ˇ0 ; ˛0? ˇ? D 0 12

where ˇ2 D ˇ? ? has dimensions p ð p r s, υ D ˛0 ˇ2 has dimensions r ð p r s

where 1Ł D 1 ˛υgQ 0 ˇ, 2Ł D 2 ˛υg

(e) LR for symmetry 2 1 D 17.0 p-value D 0.00

(f) LR for proportionality 2 2 D 35.5 p-value D 0.00

(i) unr. ˇ 0 Xt et 0.75pŁt C 0.55pt et 0.76pŁt C 0.24pt

0 Xt (left-panel) and unrestricted polynomial cointegration relation