Testing for long-run PPP in a system context: Evidence for the US, Germany and Japan

This paper extends the current literature on PPP by re-examining the validity of the PPP hypothesis for the three key currencies of the recent floating exchange rate period, in a multilateral framework. We argue that PPP testing is more adequate in a system context, which takes into account the dynamic interactions of exchange rates and prices of more than two economies, simultaneously. In the system analysis framework, some form of causality among the variables under consideration is also assessed empirically with the aid of weak exogeneity tests. The results illustrate the importance of the multilateral testing. Positive evidence for PPP is found: long-run PPP is supported for the US and Germany but also for the US and Japan, in contrast to evidence of earlier empirical studies. In addition, causality is found running from the US prices to the exchange rates and German and Japanese prices.