Purchasing Power Parity (PPP), Postulates That the Exchange Rate Between $\frac { P f } { P }$

question 36

Essay

Purchasing power parity (PPP), postulates that the exchange rate between two countries equals the ratio of the respective price indexes or ExchRate = $\frac { P f } { P }$ (where ExchRate is the foreign exchange rate between the two countries, and P represents the price index, with f indicating the foreign country). The long-run version of PPP implies that that the exchange rate and the price ratio share a common trend.
(a)You collect monthly foreign exchange rate data from 1974:1 to 2002:4 for the U.S./U.K. exchange rate ($/£)and you collect data on the Consumer Price Index for both countries. Explain how you would used the Engle-Granger test statistic to investigate the long-run PPP hypothesis.
(b)One of your peers explains that there may be an easier way to test for the validity of PPP. She suggests to simply test whether or not the "real" exchange rate, or competitiveness, is stationary. (The real exchange rate is given by ExchRate × $\frac { P f } { P }$ )Is she correct? Explain. How would you implement her suggestion? Which alternative test-statistic is available?

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