CO-INTEGRATION AS AN EMPIRICAL-TEST OF PURCHASING POWER PARITY

The use of a country's real effective exchange rate as a measure of external competitiveness implicitly assumes that, in the long run, purchasing power parity prevails between the country and its trading partners. A testable definition of long-run equilibrium existing among non-stationary time series is provided in the recently developed theory of co-integration. The existence of such a long-run "statistical equilibrium" between the U.S. inflation rate and an effective exchange-rate-adjusted inflation rate computed from its major trading partners is investigated in the paper. © 1990.