Purchasing power parity puzzle and the Australian dollar real exchange rate

This paper examines mean reversion in the real exchange rate (RER) index of Australia in the presence of structural breaks from 1984 quarter 1 till 2011 quarter 1. Testing for mean reversion in RER is one way of testing the purchasing power parity (PPP) theory of international trade and finance. Mean reversion is examined by using a minimum Lagrange Multiplier unit-root test that allows for breaks in level and trend. We were able to reject the unit-root null hypothesis and find evidence of mean reversion and hence purchasing power parity (PPP). Our finding reverses the results of past studies that failed to prove convergence to PPP in the long-run. The corresponding structural break dates are 1988 quarter 2 and 2002 quarter 4 respectively and these breaks are statistically significant. The break dates mostly correspond to the period of RER instability (1986-1989) and the recovery of the Australian dollar driven by the resources boom (2001-2002).