Since the present study of PPP employs data on price indices rather than price levels, we are examining the relevance of relative PPP: the notion that the percentage change in the nominal effective exchange rate should compensate for the inflation differential between the home country and a weighted average of partner countries. This test of relative PPP is more stringent than the usual test, which uses first differences of the real exchange rate.
Recent work on testing PPP and the stationarity of real exchange rates in developing countries includes Bahmani-Oskooee (1995) and Montiel (1997), among others; studies concentrating on Latin American countries include Devereux and Connolly (1996) and Calvo, Reinhart, and Végh (1995).
Biased and bias-corrected point estimates of the half-life of shocks to economic time series have also been used by Cashin, Liang, and McDermott (2000) in modeling the persistence of shocks to world commodity prices; by McDermott (1996), Murray and Papell (2002), and Cashin and McDermott (2003) in modeling the persistence of parity deviations in developed-country real exchange rates; and by Cashin, McDermott, and Pattillo (2004) in examining the persistence of terms of trade shocks.
See Cashin and McDermott (2003) for details on the downward bias of autoregressive parameters derived from least squares estimates of AR models and Andrews’ (1993) method for bias-correcting the least squares estimator.
The 20 industrial countries and 70 developing countries are listed in Table 1. A decline (depreciation) in a country’s REER index indicates a rise in its international competitiveness (defined as the relative price of domestic tradable goods in terms of foreign tradables).
In calculating group and all-country median half-lives of deviation from parity, a permanent deviation is defined as one that is at least as long as the span of the data. In our sample, the data span 29 years, so permanent deviation from parity (infinite shock) is set to equal 30 years.
Following Cheung and Lai (2000b), the effects of nonmonotonic reversion to parity can also be illustrated by calculating the half-life of real exchange rate shocks after the period of initial magnification. For both the United States and Nigeria, these modified half-life estimates are much shorter than the standard half-life of parity reversion, indicating that once the initial magnification period is completed, the IRFs dissipate rather rapidly. The duration of postmagnification half-lives can be calculated from Table 1 as the difference between the unbiased half-life (column 3) and the time to peak (column 4).
The next step in the research agenda attempting to solve the PPP puzzle could lie in the development and implementation of median-unbiased nonlinear estimators of the speed of parity reversion.
This result is also consistent with the median-unbiased half-lives calculated for industrial countries by Cashin and McDermott (2003).
Cheung, Chinn, and Fujii (2001) also find a nonnegative relationship between openness and the persistence of sectoral real exchange rate deviations. They attribute this result to the inverse relationship between openness and inflation (see Romer, 1993). For our sample of countries, we also find a strong negative rank correlation between openness and inflation (−0.397). This suggests that greater openness is associated with lower inflation, which implies a slower speed of parity reversion.
As a robustness check on the unconditional correlation results, least squares regression of the half-life of parity deviation on the above-mentioned structural characteristics was also carried out. As in the bivari-ate correlations, inflation is the most significant variable for reducing the half-life of parity deviations.