Index-Induced Errors and Purchasing Power Parity : Bounding the Possible Bias

With different countries' price indexes being abased on different baskets of goods, measures of inflation-differentials and price-level ratios are intrinsically subject to error. These measurement errors could bias the outcome of PPP tests which include price indexes as regressors. We apply two-way regressions to gauge whether such index-induced errors are potentially relevant. The two-way regression approach suggests the errors from inflation measurement may be very large. It also suggests that even if the measurement errors could be overcome, exchange rates behave very differently than predicted by PPP