This paper is an empirical investigation of whether the theory of purchasing power parity (PPP) describes Norwegian data well. I have used absolute price data from the Penn World Table (PWT) and constructed real effective exchange rates (REER) for Norway againstvarious groups of countries. My main focus is on an importweighted REER against a group of 40 countries. By employing simple unit root tests on this REER over the period from 1973 to 2000 I get strong rejections of the unit root hypothesis, and accordingly, firm support of PPP. The implied half-life of deviations from PPP is less than two years. This is contrary to what some previous PPP studies done on Norwegian data have found. Furthermore, I test for PPP also bilaterally, but I can only detect evidence of PPP against a few countries.
The REERs thus appear to be more stationary than most bilateral real exchange rates. This feature can be explained if it is the case for Norway that shocks to some bilateral real exchange rates are positive, whereas others simultaneously are negative. In a weighted average of several bilateral real exchange rate - a REER - these shocks may roughly cancel, making the REER more stationary.
Possible explanations for why Norway has exhibited faster mean reversion than many other countries is the policy of nominal exchange rate stability that hase been followed in the post Bretton Woods period, and the coordinated policy attempts at maintaining the competitiveness of the tradable sector that has been done.
In addition, I have tried to identify factors that explain the variability in half-life of deviations from PPP as compared with different countries. I have found that distance, the level of development and the level of bilateral trade are possible explanatory factors. Looking at nearly two centuries of data I find theNorwegian-UK real exchange rate to be trend stationary. This can be interpreted as evidence of a Balassa-Samuelson variant of PPP, as productivity growth - here measured by growth in real gross domestic product (GDP)per capita - on average has been higher in Norway than in the UK in the respective period.
Furthermore, I have tested for nonlinearities in some bilateral real exchange rates for Norway, as nonlinear models have been found to describe some other real exchange rates better than linear models. But the tests I have performed do not indicate any meaningful nonlinearity.