Common trends and generalized purchasing power parity

The theory of purchasing power parity (PPP) has worked poorly during the post-Bretton Woods period. We generalize the concept of PPP (called generalized-PPP, or G-PPP) and posit an equilibrium relationship among groups of real exchange rates. The basic tenants of G-PPP are that real fundamental macroeconomic shocks tend to be non-stationary so that the real exchange rates themselves will tend to be non-stationary. Although bilateral exchange rates are non-stationary, they will be cointegrated if the vector of stochastically trending variables has reduced rank. G-PPP will hold within the domain of a currency area since the individual nations will experience a set of common real macroeconomic shocks. Using data from the industrialized countries during the post-Bretton Woods period, we show that G-PPP holds for various groupings of nations. We estimate the long-run equilibrium relationships among the real exchange rates and the short-run dynamics concerning the international transmission of real disturbances. An interesting finding is that G-PPP does not hold among the set of major European nations. The direst implication is that such nations do not constitute the domain of a currency area.