Exchange Rate Economics: Theories and Evidence

48 Purchasing power parity and the PPP puzzle
2.2 The earlyempirical evidence on PPP
and the LOOP
In this section we consider what we refer to as the early empirical evidence on PPP
and the LOOP. By this we mean empirical work implemented using traditional
econometric methods (i.e. tests conducted prior to the development of cointegration
and unit root testing methods) in the 1970s and early 1980s for the post-
Bretton Woods and inter-war experiences with floating exchange rates. One of the
first tests of the LOOP was conducted by Isard (1977) who compared disaggregate
prices across countries. In particular,he tested the LOOP using export transaction
prices for 2 to 5 digit STIC categories between the US and Germany and export
unit values in 7 digit A and B groupings between the US and Canada,Germany
and Japan. On the basis of a regression analysis,Isard demonstrated that large
and persistent deviations of the LOOP occured for all of these price comparisons.
Isard also demonstrated that a positive correlation existed between contemporaneous
dollar exchange rates and relative dollar prices. A similar study to Isard’s,
although at a more disaggregate level,was conducted by Kravis and Lipsey (1978)
and they also fail to find any evidence supportive of the LOOP. Giovannini (1988)
compares Japanese and US export prices for disaggregated traded goods,and also
for manufactured goods which are close to being commodities,and again confirms
Isard’s result: there are large and persistent deviations from the LOOP and these
are strongly correlated with the nominal exchange rate.
Early tests of absolute and relative PPP focus on the following two expressions:
s t = β + α 0 p t + α 1 p ∗ t + ϕ t ,(2.17)
s t = β + α 0 p t + α 1 p ∗ t + ϕ t . (2.18)
Frenkel (1980,1981) presents estimates of equations (2.17) and (2.18) for the interwar
experience with floating exchange rate for the dollar–pound,franc–dollar
and franc–pound exchange rates,using both CPI and WPI price measures,over
the period February 1921–May 1925. Results supportive of both hypothesis are
reported in the sense that estimated coefficients are statistically different from
zero and numerically and statistically close to their prior values. For example,a
representative result for the franc–dollar exchange rate from Frenkel (1981) is:
s t = 1.183 + 1.091(p
t − pt ∗ ),SER = 0.054,DW = 1.70 (2.19)
(0.16) (0.11)
(2.19) where standard errors are in brackets and wholesale price indices have been
used. 6 This result makes clear the fact that the coefficient on the relative price
term is insignificantly different from unity. However,Frenkel’s (1981) estimates of
(2.17) and (2.18),for a variety of currencies for the recent floating period,produce
unsatisfactory estimates in the sense that coefficient estimates are often far from
their prior values (although see discussion later). For example,consider the estimate