Regime-switching purchasing power parity in Latin America: Monte Carlo unit root tests with dynamic conditional score

ABSTRACT

We suggest a Monte Carlo simulation-based unit root test of the purchasing power parity theory for Latin American countries. Under the null hypothesis, we use a Markov regime-switching (MS) model with unit root in the conditional location and MS volatility dynamics. Under the alternative hypothesis, the proposed test incorporates Markov regime-switching autoregressive moving average (MS-ARMA) plus MS volatility dynamics. Under both the null and alternative hypotheses, one of the volatility models estimated is Beta-t-EGARCH, which is a recent dynamic conditional score volatility model. We use data on real effective exchange rate time series for 14 Latin American countries. For each country, we estimate by Monte Carlo simulation the critical values of the unit root test. We provide an economic discussion of the unit root test results and also study the robustness of MS-ARMA plus MS volatility with respect to smooth transition autoregressive models with Fourier function.

KEYWORDS:

• Latin America
• purchasing power parity
• real effective exchange rate
• Markov regime-switching model
• Beta-t-EGARCH
• dynamic conditional score model

JEL CLASSIFICATION:

• C22
• F31
• O54

Acknowledgements

We appreciate and thank for the comments and suggestions received from Diego Aycinena, Matthew Copley and seminar participants at Universidad Francisco Marroquín.

Disclosure statement

No potential conflict of interest was reported by the authors.

Additional information

Funding

Funding from the School of Business of Universidad Francisco Marroquín and the Ministry of Economics and Competitiveness of Spain [grant number ECO2014-55496] are gratefully acknowledged.