Empirical Economics

, Volume 30, Issue 1, pp 77–91 | Cite as

Testing for PPP: Should we use panel methods?

  • Anindya Banerjee
  • Massimiliano Marcellino
  • Chiara Osbat

Abstract.

A common finding in the empirical literature on the validity of purchasing power parity (PPP) is that it holds when tested for in panel data, but not in univariate (i.e. country-specific) analysis. The usual explanation for this mismatch is that panel tests for unit roots are more powerful than their univariate counterparts. In this paper we suggest an alternative explanation. Existing panel methods assume that cross-unit cointegrating relationships, that would tie the units of the panel together, are not present. Using simulations, we show that if this important underlying assumption of panel unit root tests is violated, the empirical size of the tests is substantially higher than the nominal level, and the null hypothesis of a unit root is rejected too often even when it is true. More generally, this finding warns against the “automatic” use of panel methods for testing for unit roots in macroeconomic time series.

Keywords

PPP unit root panel cointegration cross-unit dependence 

JEL classification:

C12 C13 C22 C23 

Copyright information

© Springer-Verlag 2005

Authors and Affiliations

  • Anindya Banerjee
    • 1
  • Massimiliano Marcellino
    • 2
  • Chiara Osbat
    • 3
  1. 1.Department of EconomicsEuropean University InstituteFirenzeItaly
  2. 2.Istituto di Economia Politica - Universita’ BocconiMilanoItaly
  3. 3.European Central BankFrankfurt am MainGermany

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