Testing purchasing power parity hypothesis: a semiparametric varying coefficient approach

Traditional linear cointegration tests of purchasing power parity (hereafter PPP) hypothesis often lead to rejection of the PPP hypothesis. More recent studies allowing for some sort of nonlinearity in econometric modelings (e.g., Michael et al. J Polit Econ 105:862–879, 1997) suggest mixed results and leave this problem as an unresolved issue. In this paper, we analyze PPP hypothesis within a semiparametric framework using the varying coefficient model with integrated variables as considered by Cai et al. (J Econ 148:101–113, 2009) and Xiao (J Econ 152:81–92, 2009). Applying the cointegration test suggested by Xiao (J Econ 152:81–92, 2009), we conduct the cointegration test of PPP hypothesis between US and Canada, US and Japan, and US and UK, respectively. In contrast to the usual findings based on linear model PPP hypothesis testing, our semiparametric model-based tests support the PPP hypothesis.