Can purchasing power parity help forecast the dollar?

• 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
• ISSN: 0277-6693; 1099-131X
• DOI: 10.1002/for.3980140604

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.