The paper examines the purchasing power parity (PPP) theory of the foreign exchange rate of the yen against the currencies of the six G7 countries. We use the error-corrected five-dimensional vector autoregressive (VAR) model with structural changes in the trend function. The data cover the period of the post-Breton-Woods floating exchange rate system. The results reveal that the PPP relation alone determines the exchange rates for the USA, France, Germany, and Italy, while a linear combination of PPP and uncovered interest rate parity (UIP) relations determines that for Canada. In a model without trend breaks, the PPP relations hold only for Germany, which indicates that a correct specification of the sampling distribution of data is important. The one-step prediction based on the error correction model (ECM) outperforms the random walk model. The ECM is useful to predict the out-of-sample behaviors of the exchange rates.
- Error correction model
- One-step prediction
- Purchasing power parity
- Uncovered interest rate parity
ASJC Scopus subject areas