PURCHASING POWER PARITY OVER THE MODERN FLOAT - AN APPLICATION IN HIGHER-ORDER COINTEGRATION

Tests of the PPP hypothesis over the modern float have not fared well. One possible source of misspecification is analyzed in this paper. It is demonstrated that price levels are second difference stationary or integrated of order two [P(t) is similar to I(2)]. The necessary condition for PPP to hold as a long-run equilibrium, i.e., that the exchange rate is cointegrated with the relative price level, is augmented by a second condition that requires price levels across countries to cointegrate from I(2) to I(1). These conditions are examined using price indices from the United States and Germany and the Deutschemark/Dollar exchange rate.