Multivariate Cointegration Analysis and the Long-Run Validity of PPP

Author(s): Peter Kugler and Carlos Lenz

Source: The Review of Economics and Statistics, Vol. 75, No. 1 (Feb., 1993), pp. 180-184
Published by: The MIT Press
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180 THE REVIEW OF ECONOMICS AND STATISTICS
MULTIVARIATE COINTEGRATION ANALYSIS
AND THE LONG-RUN VALIDITY OF PPP
Peter Kugler and Carlos Lenz*
Abstract-This papertests the long-runvalidityof PPP using
Johansen's multivariatecointegrationmethodologyon ex-
change rates and domesticand foreignprice levels. Monthly
data coveringthe recent flexibleexchangerate period of the
DM vis 'avis 15 currencieslead to the followingconclusion:
PPP seems to hold in the long run for six Europeancurren-
cies: the Pound, Lira, NorwegianKrone, Schilling,Escudo
and Peseta. However,PPP has to be rejectedfor the United
States and the CanadianDollar as well as for the Belgian
Franc and the Danish Krone. Nevertheless,our analysisis
more favourableto PPP as a long-runpropertyof exchange
rates than the recent work applyingthe Engle/Granger re-
gressionmethodology.
I. Introduction
The post-1973 period of floating exchange rates is
characterized by a high degree of volatility of most
major exchange rates. In particular, the variance of the
rate of change in exchange rates is much higher than
the variance of international inflation differentials.
Thus, it is not surprising that the hypothesis of the
collapse of purchasing power parity (PPP) theory dur-
ing the seventies introduced by Frenkel (1981), became
popular among economists. However, this evidence
concerns the short-run validity of PPP, whereas most
economists consider PPP to be a long-run property of
exchange rates and relative price levels. The recently
developed unit root and cointegration methodology
offers a more appropriate econometric test of the long-
run validity of PPP. Indeed, some recent papers have
applied univariate unit root tests to real exchange rates
or Engle/Granger (1987) bivariate cointegration tests
to exchange rates and relative price levels to assess the
validity of PPP during the past floating rate period
(see, e.g., Baillie/Selover (1987); Corbae/Ouliaris
(1988); Huizinga (1987); Lothian (1987); and Taylor
(1988)). In general, the evidence found in these papers
does not support the long-run validity of PPP.
However, an Engle/Granger cointegration analysis of
monthly exchange rates and relative price levels in the
1920s (Taylor/MacMahon (1988)) and of annual data
covering 1900-1987 (Kim (1990)) does find evidence
favouring PPP.
This paper tests the long-run validity of PPP, apply-
ing the multivariate cointegration methodology pro-
posed by Johansen (1988) and Johansen and Juselius
Received for publication November 8, 1990. Revision ac-
cepted for publication November 13, 1991.
* Volkswirtschaftliches Institut, Bern.
Helpful comments of two anonymous referees are gratefully
acknowledged. Of course, all remaining errors are ours.
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(1990).1 This maximum likelihood approach allows test-
ing for PPP in a trivariate framework and avoids some
drawbacks of the Engle/Granger regression methodol-
ogy. Monthly data for DM exchange rates against 15
currencies are considered. The DM was selected as a
base currency as it is clearly the most important cur-
rency in Europe and one of the three most important
currencies in the world.
The contents of this paper are organised as follows:
Section II discusses the general problem of testing
PPP. A brief account of the methodology is given in
section III. The empirical results are reported in sec-
tion IV and section V provides concluding remarks.
II. Testing PPP in the Long Run
Consider the following relationship between the
nominal exchange rate Et (domestic currency price of
foreign currency) and the domestic and foreign price
levels P, and P,*, respectively,
Et = A(P/P,*)exp(q,t), t = 1, 2, ..., n (1)
where mq,is a zero mean stochastic error term captur-
ing all short-run deviations from PPP. Denoting logs by
lower case letters, we arrive at the linear relationship
et a= + p-p* + -1tt =1,29 ... ., n. (2)
The absolute version of PPP states that A is equal to
one, or equivalently, that (2) holds with the additional
restriction a = 0. This absolute version of PPP is a
very strong hypothesis and is not considered by most
economists to be the relevant one.2 If we assume that
Pt and P,* (as measured by price indices) cover both
traded and non-traded goods, then A is generally
different from one and depends on real factors in both
countries. This is often called the relative version of
PPP. However, (2) remains valid as a relationship be-
tween the level of et, Pt and p* provided that relative
prices of traded and non-traded goods revert to a
long-run constant mean.
The series et, pt and p* are likely to be non-sta-
tionary, i.e., they have to be differenced once in order
to become stationary. However, PPP theory tells us
that these non-stationary series are connected by a
relationship with a stationary error term. That is, they
1
Kim (1990) uses Johansen's approach to test for common
trends of exchange rates and price levels of several countries,
respectively.
2
In addition, this version of PPP obviously cannot be tested
using price indices data.
Copyright ? 1993

are cointegrated as defined by Engle and Granger.
Thus, we can test the long-run validity of PPP in the
sense of (2) by using the recently developed cointegra-
tion methodology.
III. Johansen's Cointegration Analysis
Let us define a vector Z, consisting of p = 3 ele-
ments
Z'= [ep,pJ*].
We assume that these variables are integrated of order
one denoted by I(1). That is, they have to be differ-
enced once in order to get a series with a stable and
invertible univariate ARMA representation. Long-
run PPP implies that Z',3 is stationary for /3'=
[1 -1 1]. There are different approaches available
to test this hypothesis. First, we may directly test the
stationarity of Zf3 by univariate unit root tests. Of
course, this approach does not consider the dynamic
interrelationship of the variables. Second, we may
regress et on pt and p* and test the I(O) property of
the residuals. This approach suggested by Engle and
Granger suffers from several problems. For one, the
direction of the regression, which is arbitrarily se-
lected, often leads to different results. Furthermore,
the approach breaks down when pt and p* are pair-
wise cointegrated. Moreover, the approach is static and
does not account for the dynamic interrelationship of
the variables. Finally, the hypothesis that the regres-
sion coefficients are equal to [1 - 1] cannot be tested
in a simple way. All these problems can be avoided by
using the approach suggested by Johansen and Juselius
(1990).
Consider the following vector autoregressive repre-
sentation of Z3
k
Zt = + E HTZtT + Et
T = 1
where Et is N(O, fl) distributed. Now let us consider
the following reparameterization of (3):
k-1
Azt = E
+r?Azt--Zt,+ rkZt-k +Et
Ti= 1 unit root tests for levels and first differences, which are
where rT =-I + l + +1T.
The rank of rk, the matrix determining the long-run
effects of Et on Z4, is equal to the number of cointe-
grating relationships denoted by r. These relationships
are given by
pwzr = nit 1si.t.e.a i = , r
where nqit iS integrated of order zero, although the
3This is the model considered by Johansen and Juselius
(1990), whereas Johansen (1988) deals with the case without a
constant term.
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NOTES 181
elements of Z, may be I(1). If the series are non-sta-
tionary, the long-run relationship in levels is given by
(5). Given the I(0) characteristic of qit, it is evident
that the long-run behaviour of the p elements of Zt is
determined by p - r common trends.
Given the rank property for rk, we may write
-rk = apt (6)
where ,3 is the p times r matrix of cointegrating
vectors and a is a suitable matrix of the same dimen-
sion.
The approach of Johansen is based on maximum
likelihood estimation of (4). In this framework, we can
test hypotheses for the number of cointegrating vectors
r as well as certain linear restrictions on these cointe-
grating vectors. Note that the matrix of cointegrating
vectors ,3 is not identified, but the space spanned by
the columns of ,3 can be estimated. Thus, we can test
whether ,3 can be spanned by at least r known vectors
of dimension p or whether a certain known vector is
contained in the cointegrating space. The latter test is
of special interest, as it allows us to test the hypothesis
that the real exchange rate e - Pt + P* is stationary.
For details on this approach, the reader is referred
to Johansen (1988), Johansen and Juselius (1990) and
Kunst and Neusser (1990).4
IV. Empirical Results
The analysis outlined in section III is applied to the
exchange rate of the DM vis 'a vis 15 currencies: the
Swiss Franc, French Franc, Lira, Pound Sterling, U.S.
Dollar, Yen, Austrian Schilling, Dutch Guilder, Bel-
gian Franc, Spanish Peseta, Swedish Krone, Danish
Krone, Canadian Dollar, Portuguese Escudo and Nor-
wegian Krone. Price levels are measured by the con-
sumer price index5 and the monthly data cover the
(3) Our sample size of roughly
period 1973/1-1990/11.
200 observations may appear rather large, but we note
that the recent floating rate provides us with data for
18 years, which is not very much in order to analyze a
long-run relationship.6 The application of Dickey-
(4) Fuller and Phillips-Perron-Stock-Watson univariate
not reported here, indicate that all the series in levels
are I(1), i.e., the unit root hypothesis cannot be re-
jected for levels but has to be rejected for first differ-
ences. The results of applying Johansen's approach to
4This analysis was performed using a RATS procedure
(5) kindly provided by Klaus Neusser of the University of Vienna.
5 The data source is IMF International Financial Statistics.
Consumer Price Indices are seasonally adjusted and the ex-
change rate series are end of period data.
6 The effects of increasing the sample size by the use of
higher frequency data over a fixed sample period in unit root
tests are analyzed by Shiller and Perron (1985).
182 THE REVIEW OF ECONOMICS AND STATISTICS

TABLE l.-MULTIVARIATE COINTEGRATION TESTS OF PPP, DM

vis A vis 15 CURRENCIES1977-1989

k-1
z= t+ FAZt-,+FkZt-k+et

- rk = H = a;8 1: Matrix of cointegrating vectors

[/11 1812 1313 all ... alr

=
. a = a21 *2r a
K= [1 -1 1]
Prl 18r2 /3r3 [a31 ... a3r

Z, [et,P P p, t *]

Ho: H = a/' Ho: Kcsp(/3) Ho: H = a13' Ho: Kcsp(/3)

Johansenb Johansenb
DM /... r kHQa Statistic X2rC kAa Statistic X2rC

US$ <2 2 1.34 14.5' 6 2.29

< 1 18.26e 11.93 21.9'
= 0 59.52f 36.57e
BF <2 2 3.32 6 5.23 15.8'
< 1 10.00 4l.5' 26.31
= 0 75.7l1 53.14'
DKr < 2 1 3.65 6 6.10
< 1 11.43 5. ld 13.59 7.08e
0 = 1 45.54f 31.12d
SFr < 2 2 0.016 10.lf 6 0.16
< 1 19.09e 9.19
= 0 50.19' 27.56
? < 2 2 5.00 1.84 6 4.52 0.11
< 1 25.23f 16.84d
= 0 64.33' 43.1 1i
FF < 2 2 6.91d 1.24 6 4.48
< 1 19.62e 14.16 9.89f
= 0 39.19f 28.97 d
Lit < 2 2 4.53 0.66 6 6.46 1.32
< 1 21.22e 16.20d
= 0 50.02' 39.23'
Y < 2 1 3.21 0.71 6 4.77 4.15e
< 1 16.9ld 17.49d
= 0 92.15' 57.37'
CAN$ < 2 2 1.81 9.82f 4 2.87
< 1 21.02e 14.57 25.5f
= 0 48.09' 50.0o
NLfl < 2 7 1.41 1.47 2 0.85 4.19e
< 1 16.23d 21.1e
= 0 53.68' 56.82'
NKr < 2 2 4.57 3 4.57
< 1 14.28 0.58 14.24 1.55
= 0 34.50e 29.24d
OSch <2 8 3.90 0.07 2 2.26
< 1 18.65e 11.94 0.45
= 0 39.67' 44.04'
PEsc <2 1 3.78 0.25 2 3.76
< 1 16.01d 13.35 4.30
= 0 57.53' 41.13'
SKr < 2 1 1.62 6 0.81
< 1 8.65 9.67' 8.14
= 0 45.35' 21.23
Pts < 2 2 5.29 0.35 6 7.01 2.01
< 1 23.83' 22.44'
= 0 63.l4' 71.88'

Lag length selected by using the Hannan-Quinn (kHQ) and the Akaike (kA) criterion, respectively.
b Under the Ho, this statistic has a (non-standard) distribution which is tabulated in Johansen and Juselius
(1990). The 5% critical values (without drift) are 8.08 (r < 2), 17.84 (r < 1), and 31.27 (r = 0), respectively.
c Under the Ho, this statistic is x2 distributed with 3- r degrees of freedom.
d Significant at the 10% level.
e Significant at the 5% level.
f Significant at the 1% level.

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 NOTES
our data, taking into account constant terms (A o 0),
are reported in table 1. In order to check the robust-
ness of the results with respect to the lag length, we
used two approaches. The results given in the first
columns are obtained by choosing the value of k that
minimizes the multivariate Hannan-Quinn criterion,
whereas the second set of results is obtained using the
multivariate Akaike criterion.7 For 10 currencies (US$,
BF, DKr, ?, Lit, Can$, NKr, OSch, PEsc, Pts) the
results are essentially the same for both VAR-systems
considered. All of them seem to be cointegrated (r = 2
or r = 1), but only in the case of six currencies (?C,Lit,
NKr, OSch, FEsc, Pts) can the hypothesis that the
PPP-vector is an element of the cointegrating space not
be rejected. For the remaining five currencies the re-
sults are mixed: For two of them (SFr, SKr) no evi-
dence of cointegration is found when the larger Akaike
lag length is adopted, whereas the FF, Yen and NlFl
pass the PPP test with the shorter Hannan-Quinn lag
length, but this hypothesis is rejected for the Akaike
lag length. Thus we have clear-cut results for 10 out of
15 currencies considered. For six European currencies
PPP seems to be a long-run property of the exchange
rate against the DM. The corresponding countries are
United Kingdom, Italy, Norway, Austria, Portugal and
Spain. However, PPP clearly does not seem to hold for
the exchange rate of the U.S. and the Canadian Dollar,
the Belgian Franc and the Danish Krone vis 'a vis the
DM, although exchange rates and price levels are
cointegrated. In this context it is worthwhile to men-
tion the paper of Taylor (1988), which argues that
measurement errors and transportation costs may im-
ply that PPP leads to cointegration with a cointegrating
vector ,3' O [1 -1 1]. Therefore, our findings sup-
port such a weaker variant of the PPP hypothesis for
the U.S. and the Canadian Dollar, the Belgian Franc
and the Danish Krone. For the exchange rates of the
Swiss Franc, the French Franc, the Yen, the Dutch
Guilder, and the Swedish Krone the results are mixed.
In these cases the results depend essentially on the
VAR lag length. Thus, a larger sample is needed in
order to get more accurate results for these currencies.
Finally, one may wonder whether PPP holds between
the U.S. and the Canadian Dollar. Therefore, we ana-
lyzed the corresponding exchange rate and price levels
using Johansen's approach. Here again we found one
cointegrating relationship between the variables, but
the PPP vector is not contained in the cointegrating
space.
7 In addition, we carried out the analysis using quadratically
detrended log time series. This procedure is motivated by
some evidence of a linear deterministic time trend in first
differences, which, of course, points to a quadratic determinis-
tic time trend in levels. However, the results obtained are not
essentially different from those reported in table 1.
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183
V. Conclusion
The application of Johansen's multivariate cointe-
gration methodology for 15 DM exchange rates and the
corresponding price levels using recent monthly data
lead us to the following conclusion: PPP seems to hold
in the long run for six European currencies, namely the
Pound, Lira, Norwegian Krone, Schilling, Portuguese
Escudo and the Spanish Peseta. However, PPP has to
be clearly rejected for four currencies: the U.S. Dollar
and the Canadian Dollar, as well as for the Belgian
Franc and the Danish Krone. For the remaining five
currencies (Swiss Franc, French Franc, Yen, Dutch
Guilder, Swedish Krone), we obtained mixed results
depending on the VAR lag length adopted. Neverthe-
less, our analysis is more favourable to PPP as a
long-run property of exchange rates than the recent
work applying the Engle/Granger regression method-
ology. Our results are also in line with the findings of
Abuaf and Jouron (1990) who apply Dickey-Fuller unit
root tests to real exchange rates in a seemingly unre-
lated regression framework.
Given these results we may ask whether membership
in the European Monetary System is of importance for
the non-rejection of PPP. Five currencies have been
linked to the DM by the EMS since 1979, namely, the
Danish Krone, the Belgian and the French Franc, the
Lira and the Dutch Guilder. The Austrian Schilling
was de facto linked to the DM, whereas the Peseta
entered the EMS only in the late eighties. The Swiss
Franc was only linked to the DM during one year by
the exchange rate targeting policy followed by the
Swiss National Bank (1979). With these facts, we note
that the empirical evidence for PPP within the EMS is
not stronger than for the European Countries outside
this systems.8 This should not come as a surprise as the
EMS links nominal, not real, exchange rates.
How can we explain the failure of PPP to explain the
long-run development of the Dollar? Of course, we
may argue that the shocks, in particular fiscal policy
shocks, that hit the United States in the eighties re-
sulted in permanent changes of the relative price of
traded goods in the United States. If this conjecture is
true, PPP only holds in the sense of a long-run rela-
tionship for rates of change in the exchange rate, the
domestic price level and the foreign price level.
REFERENCES
Abuaf, Niso, and Philippe Jouron, "Purchasing Power Parity
in the Long Run," The Journal of Finance 45 (1990),
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Artis, Michael J., and Mark P. Taylor, "Some Issues Concern-
ing the Long-Run Credibility of the European Mone-
8
For a univariate unit root analysis of pre- and post-EMS
real DM exchange rates the reader is referred to Artis and
Taylor (1989).
184 THE REVIEW OF ECONOMICS AND STATISTICS

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EFFICIENT ESTIMATION OF THE COSTS OF RENT CONTROLS: A COMMENT

Choon-Geol Moon and Janet G. Stotsky*

Abstract-Caudill, Ault, and Saba (1989) introduce an ap- using only the observations from the uncontrolled mar-
proachto estimatinga hedonic price equationthat accounts ket.
for censoringdue to rent controlin a rental housingmarket.
This paperextendsand clarifiestheir assertionon the consis- Caudill et al. use maximum likelihood estimation,
tencyof the ordinaryleast squaresestimates(OLS) and their recognizing the following data generation process:
estimates.We indicatehow the natureof the rent controllaw
affectsthe consistencypropertiesof the two estimationmeth- p1 = a + 3'z + Ei, i = 1,.. .,n (1)
ods. (= Pi*, if the ith observation is
from the uncontrolled market (8- 1);
I. Introduction
{i <P*, if the ith observationis
Caudill, Ault, and Saba (1989) present a method for from the controlled market (5i 0);
hedonic price equation estimation that accounts for (2)
censoring due to rent control. The traditional approach
to the estimation of the market rent equation in a where zi denotes a vector of the ith apartment charac-
rental housing market with rent control has been OLS teristics, 5i indicates rent control status, pi denotes
the latent market rent, and pi denotes the observed
Received for publication-October 9, 1990. Revision accepted
apartment rent. The triples of (pi, 8i, zi) for i =
for publication October 10, 1991. 1, .. ., n are observables while pi are unobservables.
* Rutgers University and United States Treasury Depart- They assume that Ej are normally distributed and inde-
ment, respectively. pendent over i, and derive the log-likelihood function
The authors would like to thank Denton Marks and Steven which is the same as that of the Tobit model with
B. Caudill for helpful comments on an earlier version. Special
thanks go to an anonymous referee who suggested we focus known, variable left censoring.1
on the main issue in this and earlier revisions. We gratefully
1
acknowledge the support of the Center for Urban Policy Observationally, rent control places an upper bound on
Research and the Research Council of Rutgers University. observed rent. However, since the latent market rent has a
The views expressed here are those of the authors, and do not structure relating regressors, error term and parameters, in
necessarily reflect those of the United States Treasury De- econometric terminology the latent market rent is censored by
partment. the observed rent from the left.

Copyright ?) 1993

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