Abstract
In the empirical literature there is a prevalent view that real exchange rates tend to converge towards levels predicted by the Purchasing Power Parity (PPP) only in the long-run and that short-run deviations from the PPP relationship are frequently sizable. The progressing of European monetary integration and the forming of monetary union spurred the interest of researchers to assess the relevance of the PPP theory in the case of the single European currency. Our paper therefore examines this exchange rate theory by testing a dataset of monthly real exchange rates for a sample of 11 eurozone members with respect to different benchmark currencies. Because of the documented drawbacks of linear specifications in examining this exchange rate theory, we utilise a nonlinear unit root test based on the ESTAR model proposed by Kapetanios, Shin, and Snell (2003). The results of unit root tests for the US dollar-based real exchange rate series as well as for Japanese yen-based series suggest that the PPP proposition does not hold in the case of eurozone countries. The absence of real exchange rates’ nonlinear reversion reported in this study thus confirms the thesis of Wu and Lin (2011) regarding the PPP relationship since the inception of the euro.
Highlights
The theory of Purchasing Power Parity (PPP) remains one of the most thoroughly investigated topics in the field of empirical international economics
The presence of nonlinear dynamics in real exchange rate movements is explained with a range of models taking into account transaction costs, heterogeneous market expectations about the equilibrium nominal exchange rate, nonlinearities stemming from the goods-aggregation problem and the effects of official interventions in the foreign exchange market
Following such a line of reasoning, we employed a nonlinear unit root test based on the exponential smooth transition autoregressive (ESTAR) model developed by Kapetanios et al (2003) to test the PPP concept for 11 countries of the euro area
Summary
The theory of Purchasing Power Parity (PPP) remains one of the most thoroughly investigated topics in the field of empirical international economics. In recent years researchers have been analysing various aspects of this exchange rate theory by considering a range of different methodological approaches, estimation techniques and datasets. The aim of this paper is to implement, in addition to the conventional augmented DickeyFuller (ADF) test, the Kapetanios et al (2003) (hereafter KSS) unit root test that accounts for possible nonlinear adjustment of real exchange rates for 11 countries of the euro area (EA-11). The empirical literature on the PPP theory for the original euro area economies is rather limited, while the results of explicit tests are surprisingly mixed (Chang, Chang, & Su, 2013; Christidou & Panagiotidis, 2010; Wu & Lin, 2011; Zhou & Kutan, 2011). The paper is structured as follows: Section 2 provides a brief overview of the relevant empirical literature on PPP testing for euro countries.
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a call
