Is There a Base Currency Effect in Long Run PPP?

The base currency effect in the PPP literature refers to the stylised fact that tests on real exchange rates denominated in German marks are more likely to support mean reversion than analogous tests on US dollar rates. Using a panel of 19 OECD currencies and monthly data, 1973-97, three panel unit root approaches are employed to investigate this issue - the Im, Pesaran and Shin (1995) mean group ADF estimator in its standard and demeaned versions, a SUR-FGLS panel test procedure, and the Taylor and Sarno (1998) likelihood ratio approach. In particular we explore the view that the base currency effect can be attributed to neglected cross sectional dependence and/or heterogeneous serial correlation. The tests provide qualitatively similar verdicts for both dollar and mark real exchange rates. The conclusion is that evidence for a base currency effect disappears once one allows for cross sectional dependence. Finally the panel test results generally support long run PPP which may be explained by the fact that such tests retain most of their power in the presence of potential nonlinearities as shown by Taylor, Peel and Sarno (2000)