HOME BIAS AND

PURCHASING POWER PARITY:

EVIDENCE FROM THE G-7 COUNTRIES

Nikolaos Mylonidis
Dimitrios Sideris

Working Paper
No. 59 April 2007
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BANK OF GREECE
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ISSN 1109-6691

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HOME BIAS AND PURCHASING POWER PARITY: EVIDENCE
FROM THE G-7 COUNTRIES

Nikolaos Mylonidis
University of Ioannina

Dimitrios Sideris
Bank of Greece and University of Ioannina

ABSTRACT
Recent studies in the international economics literature emphasize the role of home
bias in explaining a number of empirical puzzles. In the present study, we test for the
following hypotheses: (i) that a home bias effect, which is nevertheless falling over
time as traded goods markets become more integrated and consumption preferences
become more similar across developed countries, influences the relationship among
nominal exchange rates, domestic prices and foreign prices, and (ii) that incorporation
of the home bias effect in the empirical specification of PPP enhances the robustness
of the theory. We perform a panel data analysis using quarterly observations for the
G-7 economies in the post-Bretton Woods era. The results confirm our hypotheses.

Keywords: PPP; Home bias; Panel data.

JEL classification: F31; C33.

Acknowledgements: The authors would like to thank H. Gibson for helpful comments
and suggestions. Any remaining mistakes are our own responsibility. The views
expressed in this paper are those of the authors and should not be interpreted as those
of the respective institutions.

Address for Correspondence:

Dimitrios Sideris,
Department of Economics,
University of Ioannina,
University Campus,
45110 Ioannina, Greece,
Tel. +26510 - 95942
e-mail: [email protected].

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1. Introduction

Purchasing power parity (PPP) states that the exchange rate between two
currencies is determined by the change in the relative prices of the two countries. The
notion underlying it is that deviations from the parity represent profitable commodity
arbitrage opportunities which, if exploited, will tend to bring the exchange rate
towards the parity.

PPP is one of the most extensively analysed relationships in the international

finance literature (see e.g. the recent survey studies by Taylor, 2006; Taylor and
Taylor, 2004). Recent empirical studies on PPP make use of the concepts of
stationarity and cointegration to test for the validity of the doctrine. They use
advanced time series and panel methods and advocate extending the span of data in
either a time series (see, inter alia, Hegwood and Papell, 1998) or a cross sectional
dimension (see, inter alia, Wu and Chen, 1999). A number of recent empirical studies
produce evidence which is favourable to the validity of PPP as an equilibrium
relationship but report slow adjustment of the real exchange rate to its equilibrium
value (the half-life to equilibrium is often estimated to be three to four years).

One strand of the literature on PPP focuses on economic explanations for the
deviations from the doctrine and the slow adjustment of the real exchange rate to
equilibrium. A number of authors emphasize the role of supply-side determinants of
the real exchange rates as suggested by the popular Balassa-Samuelson model (see,
inter alia, Lothian and Taylor, 2004). Other authors consider the effects of demand
shocks such as unexpected increases in government spending (Chinn, 1999), whereas
a number of studies develop and test the “pricing to market” theories (Knetter, 1993).
Market frictions that impede commodity trade may be a source of slow reversion to
parity (Sercu et al., 1995), whereas transaction costs may produce “bands of inaction”
within which deviations from PPP are not arbitraged away by market forces (Taylor
and Peel, 2000). Exchange rate targeting and interventions in the foreign exchange
markets may also affect the adjustment to PPP and the ability to uncover PPP
empirically (Brissimis et al., 2005; Sideris, 2006; Taylor, 2004).

In a recent paper, Warnock (2003) provides an alternative economic

explanation for the observed deviations of the real exchange rates from PPP. He
argues that home-product bias in consumption spending causes deviations of the real

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exchange rate from its equilibrium value.1 To analyze exchange rate dynamics, he
develops a two-country sticky-price dynamic model which allows for home bias in
consumption patterns and indicates that asymmetric changes in money supplies
produce large short-run and small long-run deviations of the real exchange rate from
PPP.

The issue of consumption home bias is well-established in the international

trade literature. A key relationship for model analysis is the degree of substitution
between imported and domestic goods due to changes in the relative price of those
two goods, commonly known as the Armington elasticity (after Armington, 1969). A
key feature of the Armington approach to demand is the assumption that consumers
distinguish products by their source. The product-differentiation model is now widely
used in empirical international trade studies, in which consumers are assumed to
differentiate between domestic goods and their imported substitutes (see, for example,
Blonigen and Wilson, 1999).

Obstfeld and Rogoff (2000) argue that home bias, associated with
international trade costs in goods markets, may explain a number of empirical puzzles
in international macroeconomics. These trade costs may include transportation and
information costs, border costs such as tariffs and non-tariff barriers and possibly
other broader factors that impede trade. As such, trade costs tend to decrease through
time –especially during the last three decades or so- as a result of diminishing
transportation costs and the abolition of a number of tariffs, as goods markets become
more integrated.

The latter argument provides the impetus for the present paper. More
specifically, we conduct simple tests for the following hypotheses: (i) that there exists
a home bias effect which influences the relationship among nominal exchange rates,
domestic and foreign prices, and that this effect is falling over time as traded goods
markets become more integrated and consumption preferences become more similar
across developed countries, and (ii) that incorporating the time pattern of home bias in
the empirical specification of PPP enhances the robustness of the theory.2 We use

1 The importance of home bias in consumer spending in international macroeconomic models can be
traced back in Flemming (1962) and Mundell (1963).
2
In the present study, home bias is used as a generic term capturing both international trade costs and
differences in consumption preferences.

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quarterly data for the US dollar exchange rate against the currencies of the rest of the
G-7 economies for the post-Bretton Woods period 1973:1-2006:1.

The rest of the paper is organised as follows: Section 2 briefly describes the
theoretical background and presents the specifications of the theoretical arguments of
the present study. Section 3 reports the empirical analysis and results, whereas the
final section summarises and concludes.

2. The theoretical background

Recent empirical work on PPP has concentrated on the estimation of the

following long-run relationship:

st = β 0 + β1 pt + β 2 pt* + u t (1)

where st indicates the log of the nominal exchange rate denominated in the currency

of the domestic economy, pt and pt* are the logs of the price levels of the domestic

and foreign economy, respectively and u t is the error term. Strong PPP is implied by

the proportionality hypothesis H1 (β1=1, β2 =-1), i.e.,

st = β 0 + pt − pt* + u t (2)

However, strong PPP cannot be expected to hold always as an empirical

proposition -because of the effects of transportation and information costs and
measurement error problems- and is more likely to have the weak form implied by the
symmetry hypothesis H2 (β1=- β2):

st = β 0 + β1 ( pt − pt* ) + u t (3)

The panel version of (1) is written as follows:

sit = β 0 + β1 pit + β 2 pit* + vi + uit (4)

where the subscript i indicates countries in the sample, subscript t is the time period
and u it is a white-noise error term. The country-specific effect vi takes a different

value for each country and it accounts for the unobservable characteristics of the ith
country which are assumed to be time-invariant, e.g., country size effects.

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 In the present study, we assume that there exists a home bias effect, which
influences, among other parameters, the formation of the prices of the domestic
products and the consequent influence that domestic prices exert on nominal
exchange rates. In the framework of (4), the home bias effect is incorporated in the
effect of the domestic prices, as measured by β 1 . To investigate the pattern of the

home bias effect through time, we extend (4) as follows:

sit = β 0 + β1 pit + β 2 pit* + δ ( pit t ) + vi + uit (5)

where t is a time trend.3 The time pattern of the home bias is now captured by the
interaction term pit t . Assuming that the home bias effect diminishes through time,

ceteris paribus, we expect δ to be negative (δ p 0 ) .

We further investigate the role of the home bias on the estimated equilibrium
relationship between the nominal exchange rate and relative prices. To this end, we
examine whether the incorporation of home bias effects in the empirical specification,
leads to different results with respect to the estimated PPP-type long-run relationship.
We thus test for the hypotheses of symmetry and proportionality in the framework of
(4) and in the framework of (5) and compare the results.

3. The empirical analysis

3.1 The data set

PPP is tested between the USA and the economies of Germany, Japan, France,
Italy, Canada and the UK. Quarterly seasonally unadjusted data for the post-Bretton
Woods period 1973:1 – 2006:1 are used.4 The six bilateral nominal exchange rates
against the US dollar and the producer price indices (PPI) of the seven countries are
taken from the International Financial Statistics (IFS) database.5 All variables are
expressed in logs.

3
Georgopoulos and Hejazi (2005) use a similar specification to test for the existence of home bias
effects in the framework of the Feldstein-Horioka puzzle.
4
Data on PPI for France and Italy are not available prior to 1980:Q1 and to 1981:Q1, respectively,
hence resulting in an unbalanced panel data set.

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3.2 Unit root tests

In order to choose the appropriate method to estimate (4) and (5), a number of
assumptions regarding the time-series properties of the individual series are evaluated
empirically. First, we apply the t-bar test developed by Im, Pesaran and Shin (1997) in
order to test for the order of integration (stationarity) of the sit and pit series.

According to this test, the panel unit root hypothesis for sit and pit is rejected at the
conventional 5% significance level. Similarly, the ADF test indicates that the US
price index (the foreign producer price index) is stationary in levels. The unit root test
results are reported in Table 1.

3.3 The country-specific effects

In order to test for the significance of country-specific effects, we test for the
null hypothesis that all the individual cross-section dummies (vi) are jointly equal to
zero, with the aid of F- tests. The results are reported in Table 2. The respective F-
statistics take the value of 1468.767 for (4) and 1490.231 for (5). We thus reject the
hypothesis at the 1% level of significance (CV 1.32) for both cases. The results
validate the country-specific effect specifications given in (4) and (5).

We then examine whether vi is a random variable, i.e. test the hypothesis that
fixed effects do not exist. This is done using the Breusch-Pagan (BP thereafter) test,
which is distributed as χ 12 . We calculate BP=68514.93 and BP=68353.14 for the
specifications of (4) and (5) respectively, which are highly significant. The test results
reject the null hypothesis in favor of the random effects model.

Nevertheless, the BP results should be interpreted with caution, given that a

fixed effects specification might induce similar results. Hence, we apply the Hausman
test to specify whether vi are fixed or random. Hausman’s test is distributed as χ h2 ,

where the number of the degrees of freedom, h, equals the number of the regressors
(excluding the constant). The test results indicate that vi is a random variable in (4)
and a fixed variable in (5).

5
For the period 1998:1 – 2006:1 the mark/dollar, French franc/dollar and Italian lira/dollar rates are
calculated using the rates by which the mark, French franc and Italian lira were converted to euro and
the euro/dollar rate.

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3.4 Panel estimates

We proceed to the estimation of (4) and (5). The results are presented in Table
3. A heteroskedasticity consistent matrix estimator of the covariance matrix, based on
White (1980), is used to generate unbiased standard errors for inferencing procedures.
The results indicate that all estimated coefficients are correctly signed and highly
significant. Furthermore, the negative sign of the statistically significant estimated
coefficient of pit t (δ=-0.0002) in (5) indicates that the home bias effect is marginally
falling over time, thus verifying our a priori expectations. It is obvious that both the
linearity and monotonicity of this effect is the outcome of our estimating procedure.
Nevertheless, since we are interested in making the simple point that the home bias
should be falling through time, we deliberately avoid running numerous regressions
with different functional forms.

The estimated residuals are stationary in levels in both specifications, hence

providing some evidence in favor of PPP –actually in favor of a long-run relationship
linking the nominal exchange rate with domestic and foreign prices. However, further
testing is required in order to validate PPP in the alternative specifications (4) and (5).
Table 3 presents the outcomes of the likelihood ratio test statistics for alternative
hypotheses concerning the specification of the estimated long-run relationships. We
test for hypotheses H1 and H2 which imply the validity of strong and weak PPP,
respectively. H1 and H2 result in test statistics that are asymptotically χ 2 distributed
with two and one degrees of freedom, respectively. According to the test results,
neither H1 nor H2 is accepted when specification (4) is used. However, both H1 and H2
are accepted when testing is performed using the specification in (5). The findings
indicate that, when the effects of the home bias are included explicitly in the
modelling, the PPP doctrine -in both the strong and weak form- is accepted by the
data.

4. Conclusions

Recent studies in the international economics literature emphasize the role of

home bias effects, expressed either in terms of international trade costs, or in terms of
consumer spending, in explaining a number of empirical puzzles (see inter alia,

10

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Obstfeld and Rogoff, 2000; Warnock, 2003). Warnock, (2003), in particular, argues
that home bias is a source of real exchange rate deviations away from its PPP
equilibrium, in the long run. In the present paper, we test for this hypothesis assuming
that the home bias effect falls over time, as goods markets become more integrated
and consumer preferences become more similar across countries. We use quarterly
observations for the US dollar against the currencies of the rest of the G-7 economies,
for the period 1973:1-2006:1. The empirical findings support this hypothesis. In
addition, when the time pattern of the home bias effect is accounted for in the
empirical modeling we are able to accept long-run PPP in both the weak and strong
form.

11

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References
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 Table 1: Unit root test results
IPS panel unit root tests at levels
Statistic ρ-value
Exchange rate -1.71865 0.0428
PPI -7.57043 0.0000

ADF unit root test at levels

USA PPI -4.2260 0.0009
Notes: The lag selection for the unit root tests is based on Schwartz Bayesian Criterion
(SBC). IPS test includes individual effects. ADF test includes a constant.

Table 2. Tests for the presence of country-specific effects

Eq. (4) Eq. (5)
F-statistic 1468.767* 1490.231*
Breusch-Pagan test 68514.93* 68353.14*
Hausman test 2.618 667.169*
* denotes statistical significance at the 1% significance level.

Table 3. Panel estimates (1973:1 – 2006:1)

β1 β2 δ IPS ( u it ) H2 H1
eq.(4) 0.9508* -1.0805* -2.0734 55.782 56.185
(0.0283) (0.0309) [0.0191] [0.000] [0.000]
eq.(5) 0.9577* -0.9612* -0.0002* -1.7776 0.006 2.281
(0.0284) (0.0467) (<.00001) [0.0377] [0.936] [0.316]
Notes: White robust standard errors in parentheses. Marginal significance values in brackets.
The lag selection for the panel unit root test is based on Schwartz Bayesian Criterion (SBC).
The IPS test includes individual effects. * denotes statistical significance at the 1%
significance level.

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