Unit Roots, Nonlinear Cointegration and Purchasing Power Parity

We test long–run PPP within a general model of cointegration of linear and nonlinear form. Nonlinear cointegration is tested with rank tests proposed by Breitung (2001). We start with determining the order of integration of each variable in the model, applying relatively powerful DF–GLS tests of Elliott, Rothenberg and Stock (1996). Using monthly data from the post–Bretton Woods era for G–10 countries, the evidence leads to a rejection of PPP for almost all countries. In several cases the price variables are driven by permanent shocks that differ from the ones that drive the exchange rate. Also, nonlinear cointegration cannot solve the PPP puzzle.