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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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6.4 Techniques of Testing PPP Theory in Economic-History Literature

6.4.1 Comparative-Static Computation

Let E0 denote E in period 0. An obvious test of PPP theory is to measure P and P* as index numbers with value unity in base period 0 and compute V = (P/P*)E0 for either one period, a few discontinuous periods or a continuous sequence of periods. The computed V are then compared with the corresponding values of E, in a table or graph. Alternatively, (E/E0)/(P/P*) is compared with unity. In either case, the closer the computed value to the norm, PPP-predicted, value, the closer is PPP theory to fulfillment. Any noticeable divergences are then explained in terms of non-PPP influences on the exchange rate (augmented PPP theory). One can allow for a lagged effect of R on E. Further, investigations of lead-lag relationships are used to test the PPP-postulated direction of causality, from prices to the exchange rate. This entire approach has the advantage of lying outside formal statistical analysis.

6.4.2 Regression Analysis

The use of regression analysis was a natural development in testing PPP theory. For example (using lower-case letters to denote logarithms), e is regressed on P and p* or on r−1; q is regressed on a constant. Properties such as symmetry and proportionality can be readily tested in terms of elasticities.

6.4.3 Testing for Causality

The PPP relationship tested can either be an equilibrium relationship or a causal relationship, each being tested directly. A hybrid ...

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