State of the Art Unit Root Tests and Purchasing Power Parity

Although the question of whether Purchasing Power Parity (PPP) holds in the long run has been extensively studied, the answer is still controversial. Some of the strongest evidence is provided by Taylor (The Review of Economics and Statistics 84[[2002] 139-150), who concludes that long-run PPP held over the 20th century. We argue that this conclusion is quite sensitive to the use of sub-optimal lag selection in unit root tests. Using superior lag selection methods, we find that long-run PPP held for the real exchange rates of only 9 out of the 16 industrialized countries in Taylor's sample with the U.S. dollar as the base currency.