purchasing power parity a survey on east european countries (1995-2001) ioana ceanga
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Purchasing Power Parity
A Survey on East European Countries
(1995-2001)
Ioana Ceanga
The Theory of Purchasing Power Parity
-arbitrage across goods markets
-Law of One Price (LoOP)
*ii SPP
absolute PPP:
*ttt PSP
- absolute form of PPP in logarithm*ttt pps
- semi-strong form of PPP
*ttt pps
- relative form of PPP*%%% PPS
The Theory of Purchasing Power Parity
- the weak form of PPP*
21 ttt pbpbas
- Absolute PPP cannot be taken as instantaneous equality – it is a guide to long-run behavior of exchange rate
- real exchange rate
P
PSQ
*
q = s + p* - p
The Theory of Purchasing Power Parity
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 1994
- consumer price index for United States set to 100 in December 1994
Covered period: 1995:01-2001:12
(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
tttt pps *21
- 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
0.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
1995 1996 1997 1998 1999 2000 2001
LNNFXRATE_RO LNNCPI_RO LNNCPI_US
Results: 5 lags in differences included
047947.0150962.5686291.0 * ttt pps
speed of adjustments coefficients:
(-0.291 0.045 0.006)
• Testing for CZK/USD exchange rate
-.1
.0
.1
.2
.3
.4
1995 1996 1997 1998 1999 2000 2001
LNNFXRATE_CZ LNNCPI_CZ LNNCPI_US
Results: 1 lag in differences included
533709.0123911.2557164.0 * ttt pps
speed of adjustments coefficients:
(-0.007 0.009 0.004)
• Testing for PLZ/USD exchange rate
-.1
.0
.1
.2
.3
.4
.5
.6
.7
.8
1995 1996 1997 1998 1999 2000 2001
LNNFXRATE_PL LNNCPI_PL LNNCPI_US
Results: 7 lags in differences included644911.0126875.2022191.2 * ttt pps
speed of adjustments coefficients:
(-0.040 0.061 0.003)
• Testing for HUF/USD exchange rate
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1995 1996 1997 1998 1999 2000 2001
LNNFXRATE_HU LNNCPI_HU LNNCPI_US
Results: 9 lags in differences included*695194.0123420.1 ttt pps
speed of adjustments coefficients:
(-0.237 -0.050 0.00008)
• 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*ttt ppd
ttt ds
• Testing for ROL/USD exchange rate
0.0
0.5
1.0
1.5
2.0
2.5
3.0
1995 1996 1997 1998 1999 2000 2001
LNNFXRATE_RO NDIF_RO
Results: 3 lags in differences included
Trace test indicates no cointegration at both 5% and 1% levels
• Testing for CZK/USD exchange rate
-.1
.0
.1
.2
.3
.4
1995 1996 1997 1998 1999 2000 2001
LNNFXRATE_CZ NDIF_CZ
Results: 1 lag in differences included
The null of no cointegration cannot be rejected
• Testing for PLZ/USD exchange rate
-0.2
0.0
0.2
0.4
0.6
0.8
1.0
1995 1996 1997 1998 1999 2000 2001
LNNFXRATE_PL NDIF_PL
Results: 6 lags in differences included
447240.0010470.1 tt ds
speed of adjustments coefficients:
(0.014 0.073)
• Testing for HUF/USD exchange rate
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1995 1996 1997 1998 1999 2000 2001
LNNFXRATE_HU NDIF_HU
Results: 7 lags in differences included
229366.1652475.2 tt ds
speed of adjustments coefficients:
(-0.005 0.037)
• Testing the relative form of PPP
tttt xxy 2211
- 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
-.1
.0
.1
.2
.3
.4
1995 1996 1997 1998 1999 2000 2001
DFXRATE_RO
.00
.05
.10
.15
.20
.25
.30
.35
1995 1996 1997 1998 1999 2000 2001
DCPI_RO
]354.0)1([014.097358.0935.0442.1 * ARdummypps ttt
Wald test null hypothesis: c(1)=1, c(2)=-1F-statistic 2.934718 Probability 0.059117Chi-square 5.869436 Probability 0.053146
• Testing for CZK/USD exchange rate
-.08
-.04
.00
.04
.08
.12
1995 1996 1997 1998 1999 2000 2001
DFXRATE_CZ
-.04
-.02
.00
.02
.04
.06
.08
.10
.12
1995 1996 1997 1998 1999 2000 2001
DCPI_CZ
]343.0)1([008.0092.2064.0 * ARpps ttt
Wald test null hypothesis: c(1)=1, c(2)=-1F-statistic 60.35474 Probability 0.000000Chi-square 120.7095 Probability 0.000000
• Testing for PLZ/USD exchange rate
-.06
-.04
-.02
.00
.02
.04
.06
.08
1995 1996 1997 1998 1999 2000 2001
DFXRATE_PL
-.02
-.01
.00
.01
.02
.03
.04
1995 1996 1997 1998 1999 2000 2001
DCPI_PL
]394.0)1([013.0375.3003.0 * ARpps ttt
Wald test null hypothesis: c(1)=1, c(2)=-1F-statistic 8.293522 Probability 0.000542Chi-square 16.58704 Probability 0.000250
• Testing for HUF/USD exchange rate
-.06
-.04
-.02
.00
.02
.04
.06
1995 1996 1997 1998 1999 2000 2001
DFXRATE_HU
-.01
.00
.01
.02
.03
.04
.05
1995 1996 1997 1998 1999 2000 2001
DCPI_HU
008.0661.1596.0 * ttt pps
Wald test null hypothesis: c(1)=1, c(2)=-1F-statistic 1.958467 Probability 0.147780Chi-square 3.916934 Probability 0.141075
• 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