Financial integration and parity reversion in real exchange rates of emerging markets

Abstract

Johansen's cointegration technique was utilized with annual data on exchange rates and GDP deflators to investigate the validity of long-run PPP (power purchasing parity) in emerging markets during the 1955–2005 period. We found support for PPP. Given the globalization of financial markets and their impacts on the macroeconomy, PPP is a useful guide for exchange rate policy reforms.

Acknowledgements

Thanks to Dr Nomathemba Seme and an anonymous journal referee for comments and suggestions on earlier versions of the article. The views expressed in this article do not reflect the official position of Ameriprise Financial Services or its affiliates. The author accepts full responsibility for any errors or omissions.

Notes

¹ The error-correction model based on the PPP relation is specified as:

where: ECT _{t −1} is the lagged residual (error-correction term) from the cointegration regression, ∊ _t is the stochastic disturbance term, α₀ is a constant, whilst β₁, β₂ and β₃ are parameters representing elasticities, k is the length of lag and γ is the speed of adjustment. Δ is the first difference operator.