Testing the purchasing power parity: evidence from the new EU countries

Abstract

This article examines the validity of the purchasing power parity (PPP) between each of the 12 new EU countries vis-à-vis the Eurozone. Using the Johansen cointegration methodology for a period that begins from the mid-1990s and allowing for a structural break for the countries that joined the EU on May 2004, it is found that there is a long-run equilibrium relationship among the nominal exchange rate, the domestic prices and the foreign prices, for all the new EU countries. The evidence also suggests that the PPP vector enters the cointegration space for Bulgaria, Cyprus, Romania and Slovenia, which means that only for these countries the long-run PPP vis-à-vis the Eurozone is verified. For the rest of the new EU countries the long-run PPP is violated, may due to the fact that the currencies of these countries have been pegged to the euro and cannot reflect the inflation differences vis-à-vis the Eurozone.

Acknowledgements

I would like to thank the editor of the journal and an anonymous referee for useful suggestions that have improved the exposition of the article. The author would like to dedicate this paper to the memory of Professor Theodore Georgakopoulos. All the remaining errors are my own.

Notes

¹ Since January 2007, Slovenia has become the thirteenth member of the Eurozone. Also, Cyprus and Malta will join the Eurozone on January 2008.

² For the period through 31 December 1998 I used the ECU instead of the euro.

³ For the 10 countries, for which I allowed for a structural break on May 2004 due to the EU membership, the Lanne et al. (2002) critical values were used. For Bulgaria and Romania, the critical values were obtained by Davidson and MacKinnon (1993).

Table 1.  Unit root tests^a

⁴ All estimations were performed using the JMulTi software (www.jmulti.de) and the related textbook (Lütkepohl and Krätzig, 2004). For the VECMs that allow for a structural break, the critical values for the Trace tests depend on the position of the break point in the sample and were obtained by computing the respective response surface according to Johansen et al. (2000). For the VECMs with no structural breaks, the critical values were obtained by MacKinnon et al. (1999).