Purchasing Power Parity A Survey on East European Countries ( ) Ioana Ceanga

 The Theory of Purchasing Power Parity -arbitrage across goods markets -Law of One Price (LoOP)  absolute PPP:

- absolute form of PPP in logarithm - semi-strong form of PPP - relative form of PPP  The Theory of Purchasing Power Parity - the weak form of PPP

- Absolute PPP cannot be taken as instantaneous equality – it is a guide to long-run behavior of exchange rate - real exchange rate  q = s + p * - p  The Theory of Purchasing Power Parity

- If PPP is to hold in the long-run, the real exchange rate should be stationary - One way to test the stationarity of it is to find a cointegration relationship between the nominal exchange rate and the prices - Cointegration framework

Data and methods - bilateral exchange rates (ROL/USD, CZK/USD, PLZ/USD, HUF/USD)  monthly average - consumer price indexes (Romania, Czech Republic, Poland, Hungary)  set to 100 in December consumer price index for United States  set to 100 in December 1994 Covered period: 1995: :12 (72 observations)

Data and methods - unit root tests for determining the order of integration - Johansen test for establishing if there are cointegration relationships in case of the absolute and semi-strong forms of PPP - Ordinary Least Squares Method and Wald test in case of the relative form of PPP

Testing the strong form of PPP - testing the existence of long-run relationships between nominal exchange rates and consumer price indexes using the cointegration techniques - verifying the size of the CPI’s coefficients

Testing for ROL/USD exchange rate Results: 5 lags in differences included speed of adjustments coefficients: ( )

Testing for CZK/USD exchange rate Results: 1 lag in differences included speed of adjustments coefficients: ( )

Testing for PLZ/USD exchange rate Results: 7 lags in differences included speed of adjustments coefficients: ( )

Testing for HUF/USD exchange rate Results: 9 lags in differences included speed of adjustments coefficients: ( )

Testing the semi-strong form of PPP Why should the assumptions of PPP be relaxed? Different weights in the construction of price indexes The price index comprises both tradables and non-tradables Measurement errors Transportation costs Non-homogeneity of goods, tariff barriers where

Testing for ROL/USD exchange rate Results: 3 lags in differences included Trace test indicates no cointegration at both 5% and 1% levels

Testing for CZK/USD exchange rate Results: 1 lag in differences included The null of no cointegration cannot be rejected

Testing for PLZ/USD exchange rate Results: 6 lags in differences included speed of adjustments coefficients: ( )

Testing for HUF/USD exchange rate Results: 7 lags in differences included speed of adjustments coefficients: ( )

Testing the relative form of PPP - implies an OLS estimation for the equation: - applying Wald test in order to check if the coefficients estimated can be 1 or -1 - states that the proportionate change in the exchange rate is a function of the difference in the proportionate changes in home and foreign prices

Testing for ROL/USD exchange rate Wald testnull hypothesis: c(1)=1, c(2)=-1 F-statistic Probability Chi-square Probability

Testing for CZK/USD exchange rate Wald testnull hypothesis: c(1)=1, c(2)=-1 F-statistic Probability Chi-square Probability

Testing for PLZ/USD exchange rate Wald testnull hypothesis: c(1)=1, c(2)=-1 F-statistic Probability Chi-square Probability

Testing for HUF/USD exchange rate Wald testnull hypothesis: c(1)=1, c(2)=-1 F-statistic Probability Chi-square Probability

Conclusions - the assumption of no transaction costs is unrealistic - the lack of commercial barriers is not found in real life - the intervention of central banks - the costs of non-traded goods - imperfect information - the participation of other traders in the FOREX market PPP theory in all the forms studied does not hold