Two country model - unit root

Dear all,

I have encountered a problem when I try to introduce relative prices into a standard NOEM two-country model. When I introduce the relative price index PPI, just as a definition of past PPI and the difference of producer price inflation and CPI inflation (just like in the New Area Wide Model) I get a unit root. This index is therefore not the absolute price level but the relative price with PPI/CPI. Therefore it should not have influence on real variables. The model diagnostics indicate however that there is also a unit root in all my real variables such as output, exports and imports. There seems to be a colinearity problem with the equations definining PPI and the aggregate inflation (weighted average of the PPI inflation in home and foreign). Does anyone have an idea how to resolve this issue? The .mod file is attached.

Thank you in advance for your help

Best,

Björn
simplified.mod (9.37 KB)

Hi,
I haven’t seen your code. But my guess is that if you do not have Cointergration term in your productivity / endowment process, the real exchange rates would be non-stationary. The sufficient condition to induce stationarity on real exchange rates is to have ratio of endowments to be a stationary process. (See Paper by Trertvall for example)