Testing for Purchasing Power Parity in Co-integrated Panels

This paper applies the maximum likelihood panel co-integration method of Larsson and Lyhagen (2007) to test the strong PPP hypothesis using data for the G7 countries. This method is robust in several important dimensions relative to previous methods, including the well-known issue of cross-sectional dependence of error terms. The findings using this new method are contrasted to those from the Pedroni (1995) co-integration tests and fully modified OLS and dynamic OLS estimators of the co-integrating vectors. Our overall results are the same across all approaches: The strong PPP hypothesis is rejected in favor of weak PPP with heterogeneous co-integrating vectors