Testing Long-Run PPP in the Presence of Sticky Prices

In this paper we show that standard tests for long-run Purchasing Power Parity (PPP) are misspecified if aggregate prices are sticky. Using Monte Carlo simulations, we show that in small samples the ADF test has low power to reject the null of no cointegration when long-run PPP is tested using current prices instead of long-run equilibrium prices. We propose an alternative two-step testing procedure, which consists of, first, estimating long-run equilibrium prices from a standard money demand function and, then, testing long-run PPP as a relationship between the current exchange rate and long-run \QTR{em}{equilibrium} price differentials. Finally, we show that in small samples our proposed test has considerably higher power than the standard ADF test for a unit root in the real exchange rate. We apply our test to the effective exchange rate of the Greek drachma in the post-Bretton Woods period and find that it is closely linked to long-run equilibrium price differentials