Testing Stationarity of Real Exchange Rates using Johansen Tests

Recently Taylor and Sarno (1998) have proposed using a multivariate unit root test, the JLR test based on Johansen's (1989, 1991) VECM estimator, to test the stationarity of real exchange rates as implied by the purchasing power parity (PPP) hypothesis. This test has better power than univariate tests such as the ADF test proposed by Said and Dickey (1984) and a more informative alternative hypothesis than panel unit root tests. This study demonstates that these JLR tests are sensitive to the speci ̄cation of the deterministic components in the estimated model and that serious size distortions may occur in the these tests. This is shown to be especially relevant in the context of testing the PPP hypothesis.

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