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Empirical Testing of Purchasing Power Parity Validity in Selected European Union Countries

Jelko Plošinjak, Mejra Festić

Abstract


In this article, the authors carried out an empirical analysis of the validity of
purchasing power parity (PPP) in Slovenia, Croatia, the Czech Republic, Slovakia
and Austria. The results provide mixed support for PPP, which is typical for extransition
economies. In the first phase of the empirical part of the research, the
authors tested the stationarity of the real exchange rate in a logarithm, while
in the second phase, the cointegration of nominal exchange rate, domestic and
foreign price levels was tested.The Vector Error Correction Model (VECM) was
used in the third phase to test if the signs of variables are in accordance with
economics and econometrics theories, while in the final phase, restrictions
were imposed for the symmetry and proportionality of coefficients. Slovenia
is subject to limitations on the symmetry and proportionality of coefficients,
which means the validity of both the absolute and relative versions of the
PPP theory. Croatia is subject to a limitation on symmetry, but not to a limit
on the proportionality of coefficients, which means the validity of the relative
version of the PPP theory. In the case of the Czech Republic, Slovakia and
Austria, restrictions on the symmetry and proportionality of the coefficients
do not apply, which consequently constitutes an invalidity of both versions.
However, to the authors' knowledge, and taking into account Liu (1992), who
states that it is more important to check the presence of co-integration than to
check the symmetry and proportionality of the coefficients, since there is a cointegratation
between the nominal exchange rate, foreign prices and domestic
prices, the theory of PPP is valid for all the selected countries. The empirical
results suggest that all the real exchange rate time series are stationary,
additionally, cointegration exists among all the variables for all countries,
and the signs of coefficients are statistically significant for all variables in all
countries, however, the coefficient restrictions are only statistically significant
in Slovenia and Croatia.

Keywords


PPP, stationarity, cointegration, ADF test, Johansen test

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