Purchasing Power Parity When Prices Are I(2)

This paper examines the purchasing power parity (PPP) hypothesis over the modern float using data on 15 OECD currencies. Evidence is presented that suggests the price levels evolve as second‐difference stationary processes, i.e., integrated of order two (P1– I(2)). A necessary condition for PPP when prices are I(2) is that prices are cointegrated across countries to an I(1) relative price. In general this relative price is not the same as the simple price ratio. For some of the relationships examined, this relative price level is cointegrated with the exchange rate, implying a long‐run equilibrium between nominal exchange rates and prices.