Is the PPP valid for the EA-11 countries? New evidence from nonlinear unit root tests

Abstract

In the empirical literature there is a prevalent view that real exchange rates tend to converge towards levels predicted by the Purchasing Power Parity (PPP) only in the long-run and that short-run deviations from the PPP relationship are frequently sizable. The progressing of European monetary integration and the forming of monetary union spurred the interest of researchers to assess the relevance of the PPP theory in the case of the single European currency. Our paper therefore examines this exchange rate theory by testing a dataset of monthly real exchange rates for a sample of 11 eurozone members with respect to different benchmark currencies. Because of the documented drawbacks of linear specifications in examining this exchange rate theory, we utilise a nonlinear unit root test based on the ESTAR model proposed by Kapetanios, Shin, and Snell (2003). The results of unit root tests for the US dollar-based real exchange rate series as well as for Japanese yen-based series suggest that the PPP proposition does not hold in the case of eurozone countries. The absence of real exchange rates’ nonlinear reversion reported in this study thus confirms the thesis of Wu and Lin (2011) regarding the PPP relationship since the inception of the euro.

Keywords:

• Purchasing power parity
• nonlinear unit root test
• eurozone countries

JEL classifications:

• C20
• E31
• F31
• F41