Can purchasing power parity help forecast the dollar?

This paper examines the information on future exchange rate movements provided by the doctrine of purchasing power parity (PPP). Previous research has studied this issue by analyzing the time‐series properties of period‐by‐period levels of, or changes in, exchange rates. In contrast, the present stu...

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Bibliographic Details
Published in:Journal of forecasting 1995-11, Vol.14 (6), p.523-532
Main Authors: Cochran, Steven J., Defina, Robert H.
Format: Article
Language:English
Subjects:
Dollar
duration dependence
Exchange rates
Forecasting techniques
Forecasts
Foreign exchange rates
hazard function
International
Mathematical models
Purchasing power
Purchasing power parity
Statistical analysis
Studies
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Summary:This paper examines the information on future exchange rate movements provided by the doctrine of purchasing power parity (PPP). Previous research has studied this issue by analyzing the time‐series properties of period‐by‐period levels of, or changes in, exchange rates. In contrast, the present study focuses on the durations of periods in which exchange rates deviate from their PPP levels. If PPP provides information about future exchange rate movements, these durations should exhibit positive duration dependence. That is, the probability of returning to PPP levels should increase as the period of deviation increases. Parametric hazard functions estimated using data from eighteen countries provide no evidence of positive duration dependence. These results are robust to alternative definitions of PPP and to alternative functional specifications. While exchange rates take prolonged swings away from their PPP levels and then eventually return, these movements apparently constitute Monte Carlo cycles in which, at any point in time, the probability of moving back toward PPP is the same as the probability of moving farther away. Thus, PPP provides no useful information on future exchange rate changes, a result consistent with market efficiency.
ISSN:0277-6693
1099-131X
DOI:10.1002/for.3980140604