Applied Financial Economics, 1997, 7, 87Ð 95

Using a VECM to test exogeneity and

forecastability in the PPP condition
S T EF A N C . N O R R B I N , K E V I N L . R E F F E T T * and Y A O H U A JI §
Department of Economics, Florida State University, T allahasee, FL 32306 and
*Department of Economics, Arizona State University, T empe, AZ 85287 , USA

The possibility is explored that purchasing power parity (PPP) can be useful in
forecasting exchange rates and/or prices. The ® rst step shows that the spot exchange
rate is statistically exogenous in the PPP relationship. The next step investigates the
forecastability of the variables in the PPP condition. The results show that a VECM
can beat a random walk only in the case of the US price level.

I. INTRODUCTION
Recent empirical evidence has indicated support for PPP as
a long-run condition. For example, Cheung and Lai (1993),
Pippenger (1993) and Fisher and Park (1991) all ® nd sup-
port for long-run PPP using cointegration analysis. Fur-
thermore, Johansen and Juselius (1992) also ® nd support for
PPP for the UK, but only in conjunction with the un-
covered interest parity condition. Such a long-run equilib-
rium implies some short-run disequilibrium adjustment,as
pointed out by Granger (1986). This short-run adjustment
process implies some forecastability of the variables in the
PPP condition. Thus it may be possible that the existence of
a long-run PPP equilibrium will lead to a forecastable
component of exchange rates. Intuitively this means that
deviations from the equilibrium will lead to adjustments of
the exchange rates that will eliminate this disequilibrium.
Thus an `overshooting’ behaviour of the exchange rate will
produce a predictable return to the long-run equilibrium
following an innovation that causes the condition to be out
of equilibrium. The only exception to the short-run fore-
castability condition of a cointegrated relationship is if a
variable is statistically exogenous to the long-run equilib-
rium. Thus a variable may not respond by adjusting to the
new long-run equilibrium if it is statistically exogenous. In
the case of PPP statistical exogeneity of the spot rate means
that it moves due to some announcement, then prices adjust
to equilibrate the equilibrium relationship. But the spot
rate does not adjust back towards the new equilibrium,
so it would not be forecastable, but prices would be fore-
castable.
This paper tests two related issues. The ® rst is whether the
spot rate is statistically exogenous. We show how this is
important from a forecasting sense, and test which variables
are statistically exogenous in the PPP relationship. We then
proceed by using the VECM implied by the long-run PPP
and test whether we can outperform a simple random walk
forecast for ® ve countries: the United Kingdom, France,
Germany, Japan and Canada.
Section II discusses the exogeneity issue and applies it to
the PPP condition. It also considers how the vector error
correction model may be a useful approach to testing the
adjustment behaviour of the cointegrated relationship and
tests for exogeneity in the PPP condition. Section III dis-
cusses the forecasting strategy and results. Section IV is the
conclusion.
II. VECTOR ER ROR CORRECTION MODELS
A N D EX O G E N E I T Y
In this section we discuss how the dynamic adjustment
pattern to PPP will provide information about the spot
exchange rate forecastability. We also discuss how the
vector error correction models enable us to perform these
tests.

§
Please address comments to Stefan C. Norrbin, Department of Economics, Florida State University, Tallahassee, FL 32306, USA.
0960Ð 3107 Ó 1997 Routledge 87

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88
Since our focus is on the dynamic adjustment process of
PPP, we assume that a symmetric and proportional PPP
holds. If this assumption is not the case, then no signi® -
cant adjustment processes would be found to return the
variables to the long-run equilibrium. To verify that the
symmetric and proportional assumption is not the only
reason for the empirical ® ndings, we also test the system
with an estimated PPP relationship using Johansen’s (1988)
MLE methodology. Choosing the United States as the
home country, symmetric and proportional PPP places the
following long-run equilibrium restriction on spot rates and
prices:
St - PtUS + Pt = 0 (1)
where St is the log of the exchange rate in dollars per foreign
currency, and PtUS and Pt are the log of the price levels for
the US and the foreign country. Notice that the equilibrium
relationship implied by PPP is silent on issues relating to
the structure of the short-run adjustments in exchange rates
and prices to PPP and on issues relating to statistical
causality. Therefore, the actual equilibrium adjustment pro-
cess between the variables that de® ne PPP remains an
empirical issue. Interestingly, issues relating to both dynam-
ics and long-run behaviour of spot rates and prices can be
formally tested in a VECM that imposes the theoretical long
run restriction in Equation 1. This section shows how the
VECM framework can be useful for establishing the dy-
namic adjustment pattern to a long-run PPP equilibrium.
PPP in an error correction model
Many authors, including Granger (1986), Engle and
Granger (1987), Johansen (1988, 1992a), and Phillips (1991a)
have proposed econometric procedures for the systems es-
timation of a VAR in levels in the presence of unit roots.
Since there is evidence that spot rates and prices display unit
root behaviour, we begin by considering the following vec-
tor autoregression of order K for a vector of I(1) variables
X = [St , PtUS , Pt ] :
K that the variables are exogenous.
Xt = l + + Aj Xt ± j + e t (2)
j= 1
where X - K + 1 , ¼ , X0 are ® xed, and {e t} tt == T1 is a sequence of
i.i.d. Gaussian variables with mean zero and covariance
matrix X . To construct a systems estimator for this VAR, it
is important to deal with the in¯ uence of the unit roots on
the long-run behaviour of the system. It is will known that
estimating an unrestricted VAR for X in levels can be
problematic. 1 Granger (1986) notes that, in the presence of
units roots, we can solve for the change in Xt in Equation
1
See Phillips (1991b) and Phillips and Loretan (1991) for a discussion of potential problems with estimating an unrestricted VAR in the
presence of unit roots and cointegration.
S. C. Norrbin et al.
2 to obtain the following vector error correction representa-
tion:
K± 1
Xt = l + + Ci D Xt ± + P Xt ± +e
D i 1 t
i= 1
= l + C (L ) e t (3)
where
Ci = - (I - A1 - ¼ - Ai ), i + 1, ¼ ,K - 1,
P = (I - A1 - ¼ - AK )
and A1 , ¼ , AK are p 3 p matrices of parameter, and l is the
deterministic drift in D X. Notice that the long-run informa-
tion in the system is found in the P matrix.
There are many ways to estimate systems such as Equa-
tion 3. We use two of the most commonly employed in the
PPP literature: the maximum likelihood procedures in
Johansen (1988) and a generalized version of the Engle and
Granger (1987) least squares procedures. Although we use
both procedures, because of ® nite sample and identi® cation
problems associated with Johansen’s (1988) MLE proced-
ure, discussed in Phillips (1994), we focus on the Engle and
Granger procedure. Let us brie¯ y review the details of the
two procedures. For the maximum likelihood procedure,
one estimates Equation 3, using a maximum likelihood
estimator, by applying the reduced-rank regression tech-
niques pioneered in Anderson (1951) subject to a nor-
malization condition used to identify the VECM. If a coin-
tegrating vector exists then P can be decomposed using
a reduced rank regression into P = a b 9 . In this decomposi-
tion a corresponds to the error correction component of
each cointegrating vector b 9 . Alternatively, one can use
theory to impose an exact structure for b , say b *, then
estimate the error correction model in Equation 3 for the
remaining parameters and test the adjustment coe cients a .
If any of the adjustment coe cients a are signi® cant, these
variables are endogenous to the PPP condition, whereas
a failure to ® nd a signi® cant adjustment coe cient implies
The role of statistical exogeneity in estimating systems
such as Equation 3 has been investigated extensively begin-
ning with the paper by Engle et al. (1983). Exogeneity is
particularly important when attempting to understand the
dynamic adjustment process in cointegrated systems. Spe-
ci® cally for our situation, having estimated Equation 3 we
can test for the structure of the dynamic relationship be-
tween the exchange rates and prices within the context of
a long-run SPÐ PPP structure. Furthermore, tests for statist-
ical exogeneity can also test for the most parsimonious
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Exogeneity and forecastability in the PPP condition
representation for the VECM. For example, it is well known
that, given the weak exogeneity of some variables, it can be
shown that a partial system may be constructed whose
estimators will be fully e cient (Johansen, 1992a). Therefore
in this section we discuss how the presence of exogeneity can
a€ ect the estimation of systems such as Equation 3 using
exogeneity procedures described in Johansen (1992a, b),
Urbain (1992) and Norrbin and Re€ ett (1996).
Begin by partitioning the above vector series X =
[S, P US, P ] into X = [X1 , X2 ] where X1 and X2 are of di-
mension p1 and p2 and p1 + p2 . = 1. And partition the
parameters of Equation 3, a , C1 , ¼ , CK ± 1 , l , e and X ,
accordingly. The joint density of D X in the VECM in Equa-
tion 3 can be factorized into the conditional density of D X1
given D X2 , denoted D X1 | D X2 , and the marginal density of
2 1. q is a function of only Q1
D X2 as follows:
D X1 t = v D X2 t + (a 1 - v a 2 ) b 9 Xt ±
K± 1
+ + (C1 j -
v C2 j ) D Xt ±
1 where Q Î r
- v l 2 +e 1t - v e 2t
K± 1
D X2 t = a 2 b 9 Xt ± 1 + + C2 j D Xt ±
1
where v = X 1 2 X 2 21 . Notice that, in general, the parameters
±
of the conditional model and marginal model are related.
Therefore, full information estimation (such as FIML) is
required to obtain e cient estimates of that vector of
parameters in the system Q = [a , C1 , ¼ , CK ± 1 , X ]. For
example, consider estimating the ® rst p1 equations in Equa-
tion 4a. Partition the parameters according to this speci® ca-
tion of the system, e.g. a = [a p 1 , a p 2 ], Cj = [Cj p 1 , Cj p 2 ], etc.
Johansen (1992a) shows that to obtain e cient estimates of
(a p 1 , b ), we must use information implicit in the full system
speci® cation in Equation 4. This is because, in general, the
estimation of parameters (a p 1 , b ) in the partial system of
Equation 4a will involve cross-equationa l restrictions from
the full system (Equation 4). So when, for example, a 2 ¹ 0,
the parameter b 9 appears in Equation 4a and b. In this case
the estimation of (a p 1 , b , X 1 1 ) Equation 4a cannot treat
D X2 t as exogenous with respect to the estimation of the
parameters in the marginal model (Equation 4b).3
There does exist a very special case of the factorization in
Equation 4 for which a maximum likelihood estimate of the
parameters of partial system Equation 4a will be the FIML
estimate. This is when the conditional model in Equation 4a
contains as much information concerning parameters of the
cointegrating relationships in vector X as the full systems
estimator in Equation 4. This case occurs when the esti-
mates of the parameters (a p 1 , b ) in the partial system (Equa-
2
See for example Johansen (1992b) and Ericsson (1992) for a more complete discussion of this type of factorization.
3
See Phillips and Loretan (1991) and Johansen (1992a) for a complete discussion of this point.
4
See Engle et al. (1983) and Ericsson (1992) for a discussion of sequential cuts.
89
tion 4a) are variation-free with respect to the information in
the vector X2 t . A vector of parameters is variation-free if
that factorization of the conditional probability in Equation
4 forms a sequential cut. To elaborate on these terms, let
q be a vector of parameters of interest, and partition Q into
Q = [Q1 , Q2 ] where Q1 are the parameters of the condi-
tional model in Equation 4a and Q2 are the parameters of
the marginal model in Equation 4b with r 1 and r 2 the
parameter spaces for Q1 and Q2 . Then consider the follow-
ing de® nition.
DeÞ nition The variable D X2 is weakly exogenous over
a given sample period t = {1, ¼ , T } for q if and only if the
following conditions are satis® ed:
2. The factorization in Equation 4 acts as a sequential cut4 ,
1 i.e.,
F D X (D Xt , Q) = F D (D X1 | D X2 ; Q1 ) · F D (D X2 , Q2 )
+l
X1 | D X2 X2
1 1
:= r 1 3 r 2 .
(4a) The ® rst condition says essentially that the parameters of
interest q are only functions of the vector of parameters that
1 +l 2 +e 2t (4b) de® ne the conditional model in Equation 4a. The second
condition says the parameters in the conditional model and
the parameters in the marginal model are variation-free; i.e.
they do not share any joint restrictions in the system to be
estimated.
We can now describe how exogeneity in the estimation of
the vector q in the full system (Equation 4) can occur.
Consider the case of the weak exogeneity of D X2 t . Johansen
(1992a, b) proves for D X2 to be weakly exogenous for
q = [a , b ], it must be the case that D X2 does not react to any
of the disequilibrium errors in Equation 4b. Therefore, for
weak exogeneity to be present in the system D X2 t can only
respond to lagged changes in vector D Xt . In this case the
parameter b only appears in the ® rst p1 equations, and the
cross-equation restriction is completely accounted for by
Equation 4a. This makes maximum likelihood estimation of
the partial system of the ® rst p1 equations of Equation
4 fully e cient.
A stronger form of exogeneity is also possible. It could be
the case that D X2 t only responds to lagged changes in D X2 t .
And as well as being weakly exogenous, D X1 t does not
Granger-cause D X2 t . A valid conditional forecasting model
for D X1 t is therefore available by estimating Equation 4a as
a partial system. In this case, we say D X2 t is strongly
exogenous since D X2 does not respond to either lagged
D X1 t ± j ’s or any of the disequilibrium errors b 9 Xt . Notice
that, in terms of the parameters of the system (Equation 4),
strong exogeneity essentially amounts to a zero restriction
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90 S. C. Norrbin et al.
Table 1. V ECMs using a symmetric and proportional cointegrating vector

Dependent variable ECV United Kingdom

t- 1 ECV France
t± 1 ECV Germany
t± 1 ECV Canada
t± 1 ECV Japan
t± 1

D St - 0.034 - 0.010 - 0.021 - 0.010 - 0.066

(- 0.698) (- 0.239) (- 0.458) (- 0.219) (- 0.081)
D Pt 0.012 0.001 0.007 - 0.036 0.018
(1.860) (0.143) (1.190) (- 1.795) (1.090)
D PtUS 0.050 b 0.038 a 0.040 b 0.033 0.050 a
(5.585) (4.873) (5.285) (1.236) (4.514)

Notes: the VECMs all have the lag of the deviations from the theoretical PPP relationship, a constant and a deterministic trend
as regressors; no lags of the di€ erenced variables are included as the order of the VAR is 1; however, we also tested higher-order
VARs with similar result; the values in parentheses are t-statistics; the critical values are from MacKinnon (1991).
a
Signi® cance at the 5% critical value of - 4.296.
b
Signi® cance at the 1% critical value of - 4.949.

on both C2 = [Cj 2 1 , ¼ , C2 k ± 1 ]and a 2 . In this sense, the
strong exogeneity condition is much more restrictive than
the weak exogeneity condition. A ® nding of weak exo-
geneity means that the variable is unforecastable using the
long-run condition, i.e. the variable will not adjust back to
a level where the condition is in equilibrium again. Further-
more, if it is strongly exogenous, the variable is completely
unforecastable using other variables in the relationship, i.e.
the only variables that may be important for the forecasts
are the variable’s own lagged values.
T ests of exogeneity in the PPP condition
Before discussing the results of the exogeneity tests, we
discuss the data and examine the time-series properties of
the variables for non-stationarity . The data are quarterly
values from 1975:1 to 1991:4. The spot exchange rate and
producer price data are from the OECD database.5 All data
are end-of-quarter data. Logarithms are applied to all data.6
All data were found to be non-stationar y in levels, but
stationary in ® rst di€ erences. For details on the unit root
tests see Norrbin and Re€ ett (1994).
It is well known that many cointegration tests formulated
in dynamic frameworks are sensitive to the order of the lag
length (e.g. Stock and Watson, 1993). Therefore we pretest
for the order of the VAR before proceeding. Following the
suggestions in Mills and Prasad (1992), we use Schwarz’s
BIC criteria to determine the lag lengths.7 The BIC criteria
for all ® ve countries indicate a VAR of order 1. Thus
Equation 3 is estimated using no lags in the ® rst di€ erences
of X. This is also important for the exogeneity tests as it
implies that tests showing weak exogeneity also exhibit
strong exogeneity.
In Table 1 we test for exogeneity in vector error correc-
tion models for the PPP relationship. The long-run PPP
equilibrium is constrained to be symmetric and propor-
tional, and the lag length of the original VAR is 1. Thus, the
test of Equation 4a and b simpli® es to testing the signi® -
cance of a for each country in the following system:
D Xt = l + a b *9 Xt ± 1 +e t (5)
where Xt = [St , PtUS , Pt ], a is the error correction coe cient
for the system and b * is [1, - 1, 1], the theoretical cointe-
grating vector of PPP. Hence, b * 9 X is the error correction
variable, or the temporary disequilibrium for the PPP con-
dition.
Table 1 tests Equation 5 by regressing each variable on
the lagged error correction variable (denoted ECV in the
Table). OLS is e cient in this case as the vector error
correction model has the same regressors in each equation
for a given country. The results in Table 1 show that the
spot rate is weakly exogenous to the system in Equation
5 since a 1 is not signi® cant. The critical values used for the
t-statistics are higher than usual due to the null hypothesis
being non-stationarit y of the error correction variable.
Therefore the MacKinnon (1991) critical values are used.8
Intuitively the ® nding of weak exogeneity means that the
spot rate does not adjust to a disequilibrium in the PPP

5
We also tried consumer price data with similar ® ndings.
6
We also tried a monthly frequency with similar but weaker results. Furthermore, the sampling issue may be less important in this case
since our emphasis is on the long run. Hakkio and Rush (1991) have shown that the sampling frequency is less important than the length of
the time series in cointegration tests.
7
Mills and Prasad (1992) show that Akaike’s AIC criteria seems to overstate the dynamics in the system relative to the BIC criteria.
8
See Kremers et al. (1992) for a detailed discussion of critical values in extended EngleÐ Granger speci® cations.

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Exogeneity and forecastability in the PPP condition 91
Table 2. V ECMs using a SUR estimation across countries

Dependent variable ECV United Kingdom

t- 1 ECV France
t± 1 ECV Germany
t± 1 ECV Canada
t± 1 ECV Japan
t± 1

D St - 0.039 - 0.067 - 0.087 - 0.009 - 0.122

(- 0.980) (- 2.032) (- 2.537) (- 0.201) (- 2.440)
D Pt 0.002 - 0.008 - 0.008 - 0.051 - 0.008
(0.371) (- 1.698) (- 1.731) (- 2.917) (- 0.574)

Notes: the VECMs all have the lag of the deviations from the theoretical PPP relationship, a constant and a deterministic trend
as regressors; each row is estimated jointly using a SUR estimation technique; values in parentheses are t-statistics; the 5%
critical value is - 4.296, from MacKinnon (1991).

condition. 9 Similarly the foreign price level is weakly
exogenous. In fact, due to the order of the VAR, the spot
rates and the foreign price level are both weakly and strong-
ly exogenous.1 0 The change in the US price level is,
however, not exogenous. In four of the ® ve currencies the
response to the deviations from the equilibrium vector is
signi® cant at the 5% level. Only in Canada is the US price
response not signi® cant. Thus any deviation away from
PPP in the United Kingdom, France, Germany or Japan
will lead to a US price level adjustment in the future that
eventually eliminates the disequilibrium. The sign is positive
as the spot rate is the foreign currency price in dollars.
A positive value for a disequilibrium in Equation 1 can thus
be eliminated by an increase in the US price level. Obviously
the positive value for Equation 1 could also be eliminated
by negative changes in the spot rate or the foreign price
level. Although the spot rate changes in the correct direction
it is not signi® cant; the foreign price level is also insigni® cant
and most of the coe cients are of the wrong sign.
To check the robustness of the ® ndings in Table 1 we also
tested the same equations using the seemingly unrelated
regression (SUR) technique described in Zellner (1962). Al-
though it is true that the VECM system is e ciently esti-
mated by country, some additional information may exist
across countries. Thus, for example, the spot rate equation
for each country may be included in a system. The spot rate
system for all ® ve currencies is estimated using SUR to
account for the potential comovement in the error terms.
Similarly the foreign price equations can be stacked into
a system. However, the US price equation cannot be stated
in the same way because the dependent variable is the same
for each equation.1 1 Table 2 reports the SUR results for the
VECMs. Again none of the coe cients are signi® cant using
the MacKinnon critical values. The exchange rate for
France, Germany and Japan are signi® cant according to the
standard t-distribution, and also have the correct sign. Thus
some marginal evidence of overshooting exists.1 2 The
foreign price equation also improves, in the sense that all
except one coe cient are of the correct sign. However,
only the Canadian price response is signi® cant using the
standard t-distribution, and none using the MacKinnon
distribution.
In Table 3 we extend our tests by examining whether the
symmetric and proportional restriction is the reason for the
adjustment through the US price level. To address this
question we estimate the cointegrating vector using Johan-
sen’s (1988) full information maximum likelihood technique
then use the estimated cointegrating vector in our VECMs.
The equations are thus analogous to Equation 5 but the
unit cointegration vector b * is replaced with the reduced-
rank estimates of b *. The estimated cointegrating vectors
were all signi® cant, and are reported in Table 3. 1 3
For France and Japan, we ® nd the same signi® cant US
price adjustment in Table 3 as in Table 1. The results di€ er,
however, for the United Kingdom and Germany. No signi® -
cant adjustment to the error correction variable is found for
these countries. Furthermore, no other variables are signi® -
cant using the MacKinnon (1991) statistics. Germany and

9
Note that this di€ ers from the ® nding in Fisher and Park (1991). They ® nd that PPP does not hold for the US dollar, and where it does
hold, the adjustment is primarily through exchange rates. Their study di€ ers from this paper in that we use a symmetric proportional PPP
restriction and an extended EngleÐ Granger methodology as opposed to J-tests.
10
We also tested high-order VARs and found similar conclusions.
11
We have also tried to run the US price equation in one combined equation, but there is not enough space to report it. The results
indicate that the variables jointly are signi® cant, but individually they are not signi® cant. This is due to a high degree of multicollinearity.
12
This supports the ® ndings in Fisher and Park (1991) but is also a bit surprising. The results would imply that exchange rates may be
forecastable. This may imply an ine ciency in the foreign exchange market to the extent that forecastability may lead to pro® ts which
exceed the riskiness of the investment.
13
This may also explain why Fisher and Park (1991) did not ® nd a cointegrating vector for the US dollar. The disequilibrium is removed
so slowly that it may be hard to detect the existence of an equilibrium at all.

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92 S. C. Norrbin et al.
Table 3. V ECMs with estimated cointegration vectors

Dependent variable United Kingdom France Germany Canada Japan

D St 0.025 0.010 0.059 0.005 - 0.034

(2.574) (0.256) (1.896) (0.089) (- 0.400)
D Pt 0.003 - 0.003 - 0.011 - 0.050 - 0.007
(2.425) (- 0.750) (- 3.053) (- 2.025) (- 0.304)
b
D Pt US
0.005 0.031 0.005 0.033 0.064 a
(2.555) (4.377) (0.794) (0.994) (4.033)

Notes: the independent variables in each regression are the lag of the estimated cointegrated relationship, a constant and
a deterministic trend; critical values are from MacKinnon (1991).
Estimated vectors are as follows:
United Kingdom b = (1, - 15.188, 9.442)
France b = (1, - 1.459, 1.067)
Germany b = (1, - 5.532, 7.999)
Canada b = (1, - 1.390, 1.528)
Japan b = (1, - 1.902, 2.366)
a
Signi® cance at the 10% critical value of - 3.970.
b
Signi® cance at the 5% critical value of - 4.296.

Canada have some marginal adjustments of the domestic Forecasting methodology

price level, whereas the United Kingdom has some marginal
adjustments in all three variables. Therefore the adjustment
cannot be identi® ed to a single variable.
Examining the cointegrating vectors in Table 3 one
notices how di€ erent are the estimated vectors from the
theoretical vectors of (1, - 1, 1). This is very similar to what
Cheung and Lai (1993) found in their paper. Using these
estimated vectors in an error correction model gives some
counterintuitive results. The United Kingdom and Ger-
many both had signi® cant adjustments using a theoretical
vector, but not using the estimated vectors. As pointed out
by Watson (1993), if one can theoretically identify the long-
run restriction, and no evidence exists to reject this restric-
tion, then the power of the error correction procedure is
improved. 1 4 Therefore we proceed by using the theoretical
vectors.
I I I . A F O R E C A S T I N G C O MP A RI S O N
In this section we examine the exogeneity issue by conduct-
ing a forecast competition between a forecasting model
based on the adjustments toward the long-run PPP equilib-
rium and a random walk model.
The VECM (Equation 5) developed in the previous section
can be updated one period to provide forecasts as
D Xt+ 1 = m W t + a W t b *9 Xt (6)
where m W t is the estimated coe cient for all data up to time t,
and a t is the estimated coe cient for the data up to time t.
This allows true out-to-sample forecasts to be estimated by
updating the data one period at a time and forecasting one
quarter ahead.
For both VECM model and random walk model, we
must ® rst use in-sample observations (1975q1Ð 1986q4)
data to run the base regression. For out-of-sampl e fore-
casting, we adopt the rolling regression techniques
for 1987q1Ð 1991q4. This technique uses the in-sample
observations to run the base regression then update the
observation one-period at a time and compute the predicted
values for the VECM model and random walk model,
respectively. By using this rolling regression method, we end
up with ® ve years of out-of-sample predicted values for the
change of spot rates, the change of foreign prices and the
changes of US prices. By comparing the forecasted values
with the actual values, we can see which one performs
better.
.

14
In some cases more than one vector was signi® cant. This is puzzling as two signi® cant cointegrating vectors would mean that only one
common trend exists. Thus the innovation must be common to both countries. In the cases where more than one cointegrating vector was
found, the vector with the expected signs was selected.

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Exogeneity and forecastability in the PPP condition 93
Table 4. Statistical values of V ECM coe¦ cients in rolling regressions

Standard
Mean deviation Min Max

UK D S - 0.0206 0.0156 - 0.0427 0.1510

D P 0.0067 0.0049 - 0.0025 0.0129
D P US 0.0544 0.0022 0.0500 0.0586
France D S 0.0001 0.0169 - 0.0204 0.0432
D P 0.0100 0.0027 - 0.0010 0.0088
D P US 0.0436 0.0032 0.0379 0.0492
Germany D S - 0.0064 0.0212 - 0.0309 0.0417
D P 0.0052 0.0019 0.0023 0.0073
D P US 0.0468 0.0043 0.0400 0.0555
Canada D S - 0.0212 0.0459 - 0.1516 0.0169
D P - 0.0612 0.0446 - 0.1684 - 0.0289
D PUS - 0.0028 0.0562 - 0.1432 0.0427
Japan D S - 0.0449 0.0235 - 0.0687 0.0117
D P 0.0120 0.0082 - 0.0059 0.0427
D P US 0.0522 0.0017 0.0490 0.0558

The out-of-sample forecasting accuracy is measured by Results of forecasting comparison

three statistics: mean absolute error (MAE) and root mean
square error (RMSE): At ® rst, we look at the stability of the results for the rolling
regressions; we run 21 group regressions separately based
N± 1 on di€ erent observation sets. The ® rst one includes 48
MAE = + | FCt+ s - ACt+ s | /N observations and the last one includes 68 observations.
0
These rolling regressions can help to test the stability of the

5 6
N± 1
RMSE = + [ FCt+ s - ACt+ s ]2 /N
0
where FC is the ® tted change value of the variable, and AC
is the actual change value.
In order to see whether VECMs have predictive power for
the variables, we introduce the following random walk pro-
cess as a comparison:
D Xt+ 1 = m W t (7)
It is easy to see that Equation 7 can be obtained from
Equation 6 simply by ignoring the disequilibrium term of
PPP. We compare the di€ erences between actual values and
the predicted values from these two models to see which one
performs better. If the random walk model performs at least
as well as the VECM model of PPP in the out-of-sample
forecasting of some variables, then PPP does not have any
predictive power for these variables. This implies that the
variables are exogenous to PPP equilibrium and simply
follow a random walk process. But if the VECM model does
show that PPP has some predictive power for prices Ð the
VECM model improves the performance of the out-of-
sample forecasting Ð then these variables are adjusting to-
wards a long-run PPP equilibrium.
1 /2
long-run PPP relationship and the short-run dynamic ad-
justment pattern.
Table 4 gives the statistical results of the rolling regres-
sion coe cients. The coe cients, especially the coe cients
for US prices, have small standard deviations. The di€ er-
ences between minima and maxima are very close, except in
the case of Canada. This implies that the dynamic adjust-
ment patterns are stable over time. In this sense, the PPP
long-run relationship and the short-run dynamic adjust-
ment pattern are robust.
Table 5 shows that for out-of-sample forecasts, RMSE
and MAE values in the VECM model for spot rates do not
show any improvement except for Japan, compared with the
random walk process. However, the improvement for Japan
is relatively small, indicating that it may have been a func-
tion of the time period. Therefore, for spot rates, the random
walk forecasting model performs at least as well as the
VECM model. This implies that spot rates are exogenous to
the PPP relationship and simply follow a random walk
process. These empirical results are consistent with the
® ndings in the earlier section.
Earlier it was shown that at least one variable, the US
price variable, adjusts toward the long-run PPP equilib-
rium. Table 5 also supports this ® nding as RMSE and MAE

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94 S. C. Norrbin et al.
Table 5. RMSE and MAE statistics in out-of-sample forecasting

VECM Random walk

RMSE MAE RMSE MAE

UK D S 0.0695 0.0580 0.0693 0.0575

D P 0.0076 0.0062 0.0081 0.0066
D P US 0.0127 0.0093 0.0138 0.0104
France D S 0.0706 0.0598 0.0694 0.0582
D P 0.0043 0.0033 0.0043 0.0029
D P US 0.0123 0.0092 0.0138 0.0104
Germany D S 0.0745 0.0635 0.0734 0.0621
D P 0.0047 0.0036 0.0052 0.0038
D P US 0.0125 0.0093 0.0138 0.0104
Canada D S 0.0240 0.0170 0.0219 0.0157
D P 0.0099 0.0087 0.0072 0.0062
D P US 0.0153 0.0122 0.0138 0.0104
Japan D S 0.0660 0.0555 0.0668 0.0560
D P 0.0130 0.0090 0.0136 0.0095
D P US 0.0117 0.0076 0.0138 0.0104

for US prices in the VECM model are smaller than RMSE

and MAE values for the random walk process, except in the
case of Canada. This means US prices do adjust toward
PPP in most cases. Canada exhibits no improvement in the
forecasts for any of the variables, implying that they are all
independent of the PPP relationship. This also supports the
® ndings in Section III.
For foreign prices, RMSE and MAE provide some mixed
results. For the UK, Germany and Japan the VECM model
outperforms the random walk model. For France the
RMSE values are exactly the same for the VECM and
random walk, but MAE is smaller in the random walk model.
These results imply that the PPP relationship has some
forecastability components in prices, and the VECM model Fig. 1 Spot rates, out-of-sample forecasts: (Ð Ð ) actual growth,
does forecast better for prices in some cases. The results (´ ´ ´ ´) forecasted growth using PPP model, (Ð ´ Ð ´) forecasted growth
support the idea that PPP is a long-run equilibrium, and using random walk model
there are dynamic adjustments toward PPP in the short run.
Further support is provided by plots of the forecasts and
actual values. Figures 1 to 3 are for Germany but the plots negative predicted values at the beginning. The rolling re-
are typical. Figure 1 exhibits the actual change, the forecasts gressions do pull up the random walk forecasts, but not
of the random walk and the forecasts for the PPP forecast- enough to be close to the actual values.
ing model for spot rates over the period 1987q1Ð 1991q4.
The random walk forecasts and the PPP model forecasts are
very close, and both models perform poorly when forecast- I V . C O N CL U S I O N S
ing values for actual spot rates. Figure 2 shows the forecasts
for the German price level. The forecast values from the This paper has demonstrated that forecasts of the exchange
PPP model are slightly better than from the random walk rate are not going to be improved by including the PPP
model. Figure 3 shows the forecasts for the US price. The variables in the forecast regression. It shows that the
PPP model forecasts a stable positive change of US price, PPP condition can be thought of as a long-run equilib-
which is reasonable for the period except during rium. A long-run equilibrium (or cointegrated relationship)
1990q4Ð 1991q1 (big decrease of price). The random walk implies an adjustment path to reach it. However, the results
model predicts an almost zero change of the US price. The show that the spot exchange rate is weakly and strongly
substantial negative trend of the in-sample regression led to exogenous to the equilibrium attractor process. Thus the

AFES 94328
Exogeneity and forecastability in the PPP condition
Fig. 2 German prices, out-of-sample forecasts: (Ð Ð ) actual growth,
(´ ´ ´ ´) forecasted growth using PPP model, (Ð ´ Ð ´) forecasted growth
using random walk model
Fig. 3 US price level, out-of-sample forecasts: (Ð Ð ) actual growth,
(´ ´ ´ ´) forecasted growth using PPP model, (Ð ´ Ð ´) forecasted growth
using random walk model
spot rate will not adjust even if the PPP condition is in
disequilibrium. This ® nding implies that the PPP disequilib-
rium variable should be useless in a forecasting equation of
the exchange rate.
However, forecasts using a forecasting equation with
a long-run PPP variable are better than forecasts from
a random walk for the US price levels. Furthermore, the
statistical test show that the US price level is the only
variable that adjusts towards the PPP equilibrium. Thus
PPP provides no improvements in spot rate forecasts, but is
useful for US price forecasts.
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