Purchasing Power Parity Revisited: A Time-Varying Parameter Approach

We re-examine the validity of Purchasing Power Parity (PPP) proposition using Taylor's (2002) data set. Applying the Kalman filter process, our findings not only demonstrate the strong instability in the relationship between the dollar denominated foreign price levels and the US price level, but also rule out the empirical validity of the PPP hypothesis. Thus, we argue that the inference based on the Fisher-Seater methodology cannot account for the Lucas critique in the PPP testing procedure.