Econometric testing of purchasing power parity in less developed countries: fixed and flexible exchange rate regime experiences

Abstract

We investigate the Purchasing Power Parity (PPP) hypothesis for 16 Less Developed Countries (LDCs), from all over the world, during their fixed and flexible exchange rate experiences over the period 1957:01–1999:12. The main contribution of this article to the empirical literature on PPP is that our study is the first to consider PPP hypothesis on alternative exchange rate regimes for LDCs. The bilateral exchange rates of LDCs and the United States, and their respective price levels are considered. Three different time series methodologies are employed: unit-root tests, Engle–Granger (1987) cointegration technique and Johansen multivariate VAR methodology (1988). The cointegration techniques improve the results, which allows the examination of the more frequent long-run relationship between relative prices and nominal exchange rates. Nevertheless, using each of econometric techniques we find only a few and a nearly equal evidence in favour of PPP under the alternative regimes in LDCs. Hence, the main conclusion of our study is that the deviations from PPP in LDCs cannot be attributed to the exchange rate regime system. Other market regulations should be investigated.

Notes

¹ PPP is discredited as a tool to estimate the behaviour of the nominal exchange rate both in the short- and medium-run. Empirical evidence of Frenkel (1981) and Krugman (1978) rejects PPP in the short-run. However, as a long-run equilibrium relationship, PPP is a meaningful measure, so this has been the objective of the most recent studies.

² Please see Taylor and Taylor (2004) for the detailed literature review on PPP.

³ There are many versions of PPP; however, absolute PPP and relative PPP are most commonly considered versions. The relative version of PPP implies that the nominal exchange rate can differ from the price ratio by a multiplicative constant.

⁴ Please see Heather (1996), Rogoff (1996) and Taylor (2006) for detailed discussion about the popularization of PPP as an empirical tool and the detailed discussion on PPP literature.

⁵ Holmes (2000) considers a group of African countries whose liberalization experiences took place later than Bretton Woods experience. Thus by separating data according to Bretton Woods era his aim is not to distinguish fixed and flexible regimes of those countries.

⁶ The PPP studies on LDCs contain at least 9 years data, see Soofi (1998).

⁷ Further discussion of the construction of Table 3 is available upon request.

⁸ The application of unit-root tests and the Engle–Granger two-step approach on PPP and the detailed derivation of their empirical results can be provided by author upon request.

⁹ The tests are executed by employing e-views packet program. Ostewald–Lenum critical values are used to interpret test results at 1 and 5% significance levels.

¹⁰ Mexico's fixed regime period (1957–1975) has enough length including 18 years. However, during this period, its exchange rate series is constant; this leads to near singular matrix in all applications. Therefore, we have to omit Mexico's fixed regime period. Moreover, Brazil has no fixed regime experience during its entire sample period 1979:12–1999:12. Hence, we consider with the exceptions of Mexico and Brazil, 14 LDCs at fixed regime tests.

¹¹ The tests are executed by employing e-views packet program. McKinnon critical values are used to interpret test results at 1, 5 and 10% significance levels. If stationary is not established after first differencing, the ADF test for the second difference of the series is also employed.

¹² For the flexible exchange rate regime period, just 13 countries out of 16 are considered. Because of the lack of sufficient data in Thailand, Malaysia and Kenya, they are not considered at all (for detailed discussion see data section of the study).

¹³ Test results claim that Colombia and Venezuela have respectively one and two cointegrating vectors at 1% significance level, and both have three cointegrating vectors at 5% significance level. Since, our ADF test results find the nonstationarity of exchange rate and price series for these countries, to be consistent with our unit-root analysis we take account the maximum eigenvalue test results at 1% significance level.