PPP and the real exchange rate-real interest rate differential puzzle revisited: evidence from non-stationary panel data

This paper examines the evidence for two of the relationships that underpin (explicitly or implicitly) much of international macroeconomics. The first is purchasing power parity (PPP), or the hypothesis that there exists a constant long-run equilibrium real exchange rate. The second establishes a relationship between real exchange rates and real interest rate differentials. The tests are conducted on a panel of 18 OECD economies using the United States as a numeraire for the post-Bretton Woods era. The results are obtained using new non-stationary panel estimation techniques, which significantly increase the power of the tests. All the tests suggest that there is little evidence supporting PPP when it is tested directly. This contrasts with earlier panel data studies, which tended to find that the real exchange rate was stationary. The results supporting a long-run relationship between real exchange rates and real interest rate differentials appear to be more positive. This again provides a contrast with earlier results, which tended to find no evidence of cointegration. Such studies concentrated on G7 economies. To investigate this further the panel was split into two groups: the G7 and eleven small open economies. For the panel of small open economies strong evidence in favour of cointegration is found. In contrast, there is no evidence of cointegration in a panel that consists purely of the G7 economies.