Testing PPP by means of ZNZ patterned VECM

T. J. Brailsford, Jack Penm*, R. D. Terrell

*Corresponding author for this work

Research output: Contribution to journalArticleResearchpeer-review

Abstract

Vector error-correction models (VECM) are increasingly being used to capture dynamic relationships between financial variables. Estimation and interpretation of such models can be enhanced if zero restrictions are allowed in the coefficient matrices. Conventional use of full-order models may weaken the power of statistical inferences due to over-parameterization. The paper demonstrates the usefulness of this approach for the analysis of exchange rate relationships. Specifically, the paper examines the relationship between the money supply and the Euro and provides a test of purchasing power parity (PPP) in Japan. The latter test results shed light on the adjustment mechanisms through which PPP is achieved. In addition, it is clear that the proposed ZNZ patterned VECM modeling provides better insights from this kind of financial time-series analysis. The paper also shows that causality detection in an I(d) system can be revealed identically from the ZNZ patterned VECMs or the equivalent VAR models.

Original languageEnglish
Pages (from-to)345-362
Number of pages18
JournalInternational Journal of Theoretical and Applied Finance
Volume11
Issue number4
DOIs
Publication statusPublished - Jun 2008
Externally publishedYes

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