Exchange Rate Determinants Using a Reduced Form of Purchasing Power Parity Model with Relative Prices of Non-tradable and FM-OLS Cointegration Methodology

Abstract

The aim of this paper is to investigate the determinants of nominal and real exchange rates by introducing a model utilizing the reduced form of purchasing power parity (RF-PPP) suggested by Deloach. The key feature of the model is that relative prices of non-tradable goods are taken as an empirical proxy variable in formulating a testable hypothesis which is extended with lagged variables. Fully modified-OLS (FM-OLS) cointegration methodology with IFS database is employed for empirical analysis. Empirical evidence reveals that relative prices of non-tradable goods are consistent with predictions for long-run relationships between level of prices and exchange rates. Accordingly, these predictions are highly explainable when the real exchange rate and lagged variables are involved in the analysis. Findings suggest that level of prices still plays an important role in causing a long-run equilibrium in the foreign exchange markets. It also has to be mentioned that the impact of economic shocks is asymmetrically transmitted to tradable and non-tradable goods. Therefore, trade policy should be implemented elaborately to take care of the level of prices which is originated from non-tradable goods. Such policy would help to avoid imbalance between tradable and non-tradable goods.