Exchange Rate Economics: Theories and Evidence

The economics of the PPP puzzle 85
significant in each case (since this can be of either sign and still be consistent with
pricing to market not regarded as an issue). The interest differential is correctly
signed in each case,but usually only weakly significant. To interpret the remaining
vectors,Feenstra and Kendall (1997) sum the first and second vector to produce
a relationship without the interest differential (again normalised on the exchange
rate) and by summing all three vectors they produce a third relationship which is
absent both the interest differential and the average traded goods price.
To gain further insight into the cointegrating relationships Feenstra and Kendall
calculate the standard deviations of the residuals from each of these vectors. The
standard deviation of the first two vectors is always much smaller than the third and
a comparison of the residuals from the first and second suggest that it is the PTM
term which is producing the reduced standard deviation. In particular,they show
the PTM term explains about one-sixth of the deviations from PPP for Canada,and
more than one-third for Japan and the UK. The exception is Germany where the
inclusion of the interest differential is crucial in reducing the residual standard deviation.
Feenstra and Kendall further demonstrate that their results are not sensitive
to the choice of the aggregation parameter used to construct the PTM term.
Cheung,Chinn and Fujii (1999) seek to explore the consequences of market
structure for the persistence of deviations from PPP. They capture persistence using
the mean reversion coefficient for industry i of country j as:
MRC j i
= 1 + δ.
This is then regressed onto two measures of market structure and a number
of macroeconomic variables. The first measure of market structure is the price
cost margin (PCM) which approximates profits of an industry and is intended to
give a measure of how competitive an industry is:
PCM j i,t
= V j
i,t − M j
i,t − W j
i,t
V j
i,t
(3.28)
where V is the value of total prod, M is cost of materials and W is the wage. The
second measure is the intra-industry trade index (IIT) defined as:
ITT j i,t
≡ 1 − |EXj i,t − IMj i,t |
(EX j i,t + IMj i,t ) (3.29)
where EX and IM represent sectoral exports and imports. A large value of ITT
represents a high level of market power due to product differentiation.
Using sectoral real exchange rate data (for 9 manufacturing sectors) from 15
OECD countries over the period 1970–93,Cheung et al. show that both market
structure effects are significantly positively related to the mean reversion speed
and robust to different specifications; the macro variables are,however,not robust
to different specifications. They also show that industries with high PCMs have
slowest mean reversion.