Purchasing Power Parity: A Unit Root, Cointegration and VAR Analysis in Emerging and Advanced Countries

Abstract

The purpose of this study is to investigate the validity of the absolute version of the purchasing power parity (PPP) of a sample of four advanced and four emerging countries covering the period from 1993 to 2014. To examine the existence of PPP we apply the Augmented Dickey-Fuller, DF-GLS and KPSS tests for non-stationarity, and the Johansen procedure for cointegration between exchange rates and consumer price indices. The impulse response function presents a graphical view which is consistent with impressions from the statistics of stationarity tests. We also employ the variance decomposition method to analyze the movements in the exchange rates and the price indices that are caused by their own shocks, and shocks caused by other variables. With respect to half-life estimates, the results from a shock to the real exchange rate range from 0.81 to 6.45 years (3.23 years on average). Overall, unit root tests show that absolute PPP may not hold, but this depends on the country and the selected method. In contrast, the Johansen approach does not support the existence of PPP for both developed countries and emerging market economies.