PREDICTABLE COMPONENTS IN EXCHANGE-RATES

This study tests the validity of long-run PPP by applying the cointegration methodology of Johansen and Juselius (1990) to monthly exchange rate and price data for eleven countries. The results reveal that in all cases the theoretical PPP-vector [11 -1] or [11 -1, c] is not contained in the cointegration space. This finding is inconsistent with strict long-run PPP. Alternatively, evidence from unrestricted tests shows that, with one exception, one or two cointegrating relationships do exist. Given the existence of tariffs, transportation costs, and differences in the construction of price indices across countries, PPP may be consistent with a cointegrating vector other than [11 -1] or [11 -1, c]. In fact, the widespread evidence of cointegration obtained from the unrestricted tests suggests that the possibility of PPP for U.S. Dollar exchange rates for the recent floating rate period should not be dismissed.