Exchange rate and long-run price relationship in 19 selected European and LDCs

Abstract

PurposeThis study aims to make a comparative study of the applicability of the purchasing power parity (PPP) in selected less developing countries (LDCs) on one hand and European countries on the other hand.Design/methodology/approachThe research design is empirical and ex post facto. This study uses an assortment of co-integration tests and error correction representation. The chosen approach allows for the consideration of long-run elasticities and the dynamics of the short-run adjustment of exchange rates to changes in domestic and foreign prices. Monthly data are used for the period 1980:1 through 2015:12 (i.e. 432 observations).FindingsResults from long-run co-integration analysis, short-run error correction models and persistence profile analysis overwhelmingly confirm the validity of PPP in these two sets of countries regardless the disparity in their relative exchange rate and price characteristics.Research limitations/implicationsCuriously, several of these empirical studies and still many more, have focused their attention on the experiences of industrialized countries, with a few investigations devoted to LDCs. The evidence is even scarcer in Africa. Clearly, the acceptance of any hypothesis as a credible explanation of economic reality hinges on the robustness of the hypothesis across countries with different economic and institutional frameworks.Practical implicationsKnowledge of the extent to which exchange rate and relative prices can be linked in the long run is important for the design and management of inflation and the implementation of monetary policy. For instance, policy actions aimed at stabilizing the domestic economy can obtain results that are, at best, uncertain in the absence of correct characterization of the PPP dynamics. Moreover, structural and macroeconomic adjustment programs implemented in these countries to achieve economic growth and external competitiveness could be unsuccessful if flawed estimates of PPP exchange rates are retained.Originality/valueSeveral empirical studies have been done to prove the validity or otherwise of the PPP. Unlike prior authors, this study makes a comparative study of the applicability of the PPP in selected LDC on one hand and European countries.