Purchasing Power Parity (PPP), Postulates That the Exchange Rate Between $= \frac { P ^ { f } } { P }$

Essay

Purchasing power parity (PPP), postulates that the exchange rate between two countries equals the ratio of the respective price indexes or ExchRate $= \frac { P ^ { f } } { P }$ (where ExchRate is the foreign exchange rate between the two countries, and $P$ represents the price index, with $f$ indicating the foreign country). The long-run version of PPP implies that that the exchange rate and the price ratio share a common trend. (a) You collect monthly foreign exchange rate data from 1974:1 to 2002:4 for the U.S./U.K. exchange rate $( \$ / £ )$ and you collect data on the Consumer Price Index for both countries. Explain how you would used the Engle-Granger test statistic to investigate the long-run PPP hypothesis.