Testing Purchasing Power Parity under the Null Hypothesis of Co-Integration

This paper analyzes monthly data on the exchange rates and price indices of the eleven major industrial countries over the modern period of floating exchange rates. It presents tests that are based upon the null hypothesis of cointegration. The paper finds evidence that most country pairs not involving North American currencies have exchange rates and price indices that are cointegrated. It estimates the error correction representation for the series that are cointegrated and it shows that the dynamic adjustment of the relationship between exchange rates and prices is accomplished almost entirely in the market for foreign exchange.