This paper presents a general framework to address several issues that have
arisen in recent work that investigates purchasing power parity (PPP) and
other inter-regional relative price movements: (1) How can we model real
exchange rate movements in a consistent manner, so that our model for the real
exchange rate for country B relative to country C is commensurate with our
models for country A/ country B and country A/ country C real exchange rates?
For example, can things be modeled so that our tests do not depend on the "base
country"? (2) How should we handle correlation across real exchange rates in
panel tests of PPP? (3) Are speeds of adjustment toward PPP different for
intra-national, cross-national and cross-continental real exchange rates?
(4) Is the innovation variance different for intra-national, cross-national
and cross-continental real exchange rates; and, if so, how does that
influence how we model and test PPP?
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Last update: July 19, 2001