Question

What does the failure of PPP hypothesis in data teach us about real-exchange-rate volatility?

(Please be brief.)

Answer 1

One possible reason that PPP does not hold is the symmetry and proportionality condition on PPP (strong version of PPP). One implication of unit root tests is that the restrictive conditions of proportionality and symmetry restrictions are satisfied in PPP. That is, nominal exchange rates and aggregate price ratios move together in a one-to-one fashion in the long run. However, transportation costs, and differences in the composition of price indexes may each lead to violations of proportionality and symmetry in PPP, leading to the looser definition of so-called “weak” PPP; the weak version of the PPP hypothesis states that nominal exchange rates and aggregate price ratios may move together in equilibrium, but the relationship need not necessarily be one-to-one. Further future studies testing for weak PPP is typically facilitated by the technique of cointegration. The Cointegration test for PPP is that it relaxes the restriction of symmetry or proportionality imposed by unit root tests of real exchange rates