Testing the purchasing power parity through I(2) cointegration techniques

This paper contributes to the empirical literature on the purchasing power parity (PPP) over the post-Bretton Woods period by providing a time-series based interpretation of the controversial evidence characterizing the dynamics of real exchange rates. It is shown that the persistence of deviations from the PPP between a set of European countries and the United States may be empirically attributed to the presence of I(2) stochastic trends in prices using Consumer Price Indices. Interestingly, the slow adjustment towards the equilibrium can be modelled through ‘integral-proportional’ equilibrium correction models and this evidence can be partly reconciled with theories where the inflation rate reduces the markup of profit-maximizing firms acting on imperfectly competitive markets.