Purchasing power parity, price indices, and exchange rate forcasts

This paper addresses the issue of using aggregate price indices for purchasing power parity (PPP) tests and the fitness of PPP as a model for exchange rate forecasting. Compared with consumer price index (CPI) and wholesale price index (WPI), the price index of traded-goods (TPI) appears to be a more appropriate price index for both PPP tests and exchange rate forecasting. It performs better in the tests and provides superior exchange rate forecasts, both within- and out-of-sample. While the half-life of the estimated deviations from PPP is about two years for the CPI and WPI-based real exchange rates, it is only one year for the TPI-based real exchange rates.