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July/August 1993, 
Vol. 75, No. 4
Posted 1993-07-01

Hypothesis Testing with Near-Unit Roots: The Case of Long-Run Purchasing-Power Parity

by Michael J. Dueker

As a principle, it has long been asserted that the quantity of goods one can buy with a given currency, such as the dollar, should be equal across countries, at least in long-run equilibrium. This condition, known as long-run purchasing power parity (PPP), has been subjected to numerous empirical tests. One source of disagreement in statistical tests of PPP has been the choice of null hypothesis: Tests whose null hypothesis is that PPP holds often fail to reject PPP, while tests whose null hypothesis is that PPP fails often come to the opposite conclusion. Thus, there is a danger in testing only one null hypothesis for a broad set of countries, failing to reject it, and concluding that the evidence is clearly for or against PPP. In this article, Michael J. Dueker tests post-1973 monthly data from major countries using a long-memory model. The advantage of this approach is that one can test both null hypotheses with the model and demonstrate that it is unclear whether long-run PPP holds, because real exchange rates have near-unit roots, which may preclude strong conclusions as to whether real exchange rates are mean-reverting.

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