Investigating the Validity of the PPP Hypothesis Using Constructed U.S. Dollar Equilibrium Exchange Rate Misalignments over the Post-Bretton Woods Period

This paper investigates the PPP-hypothesis over the post-Bretton Woods period using a representation of the equilibrium exchange rate (EER) that is an alternative to the real exchange rate. The results provide evidence in support of the relative-PPP hypothesis over the current period of floating exchange rates (1974–2005); while stronger evidence is found for the post-Plaza Accord period (1986–2005). EERs based on export price indexes (EPI) and constructed traded goods price indexes (TPI) best demonstrate the mean reverting behavior of the spot exchange rate as opposed to those EERs based on CPI, PPI, or the GDP-deflator. This mean reverting behavior is slightly improved if one takes international interest rate differentials into account; however EERs extended by productivity differentials do not indicate any improvements over the base model. Over the post-Plaza Accord period average half-lives of less than 1 year are reported using TPI-based EERs, adjusted by interest rate differentials. For large misalignments, we find probabilities that the spot exchange rate will converge towards the constructed CPI-based equilibrium exchange rate of up to 80%. Lastly, over the post-Plaza Accord period, the TPI-based EERs are able to statistically significantly outperform the pure random walk at short-term forecast horizons of less than 1 year for some spot exchange rates.