Testing PPP q t =  +  q t-1 + e t If  = 1  unit root If  = 1  unit root Usually unable to reject null hypothesis of  = 1 Usually unable to reject null hypothesis of  = 1 However, likely reflects low power However, likely reflects low power

Resolutions Use longer time series Use longer time series But span different exchange rate regimes But span different exchange rate regimes Use panel data Use panel data Apply unit root tests to panels of countries Apply unit root tests to panels of countries

Nonlinearities Many tests assume that the speed of adjustment to PPP is uniform over time (that is, the “autoregressive parameter”, , is constant over time) Many tests assume that the speed of adjustment to PPP is uniform over time (that is, the “autoregressive parameter”, , is constant over time) Reasons to think that adjustment speed may not be constant Reasons to think that adjustment speed may not be constant Transportation costs Transportation costs

Time-varying equilibrium real exchange rate Shock to steady-state level of net external assets Shock to steady-state level of net external assets Balassa-Samuelson Balassa-Samuelson

Balassa-Samuelson If productivity growth in tradable sector outpaces productivity growth in non- tradable sector  higher aggregate price level If productivity growth in tradable sector outpaces productivity growth in non- tradable sector  higher aggregate price level Reading: Obstfeld & Rogoff 4.1 and 4.2 (excluding 4.2.4) Reading: Obstfeld & Rogoff 4.1 and 4.2 (excluding 4.2.4) Class notes Class notes