The Purchasing Power Parity in Emerging Europe: Empirical Results Based on Two-Break Analysis

Abstract

The purpose of the paper is to evaluate the validity of purchasing power parity (PPP) for eight countries from the Emerging Europe: Hungary, Czech Republic, Poland, Romania, Lithuania, Latvia, Serbia and Turkey. Monthly data for euro and U.S. dollar based real exchange rate time series are considered covering the period: January, 2000 - August, 2011. Given significant changes in these economies in this sample it seems plausible to assume that real exchange time series are characterized by more than one time structural break. In order to endogenously determine the number and type of breaks while testing for the presence of unit roots we applied the Lee-Strazicich approach. For two euro based real exchange rate time series (in Hungary and Turkey) the unit root hypothesis has been rejected. For the U.S. dollar based real exchange rate time series in Poland, Romania and Turkey the presence of unit root has been rejected. To assess the adjustment dynamics of those real exchange rates that were detected to be stationary with two breaks, the impulse response function is calculated and half-life is estimated. Our overall conclusion is that the persistence of real exchange rate in Emerging Europe is still substantially high. The lack of strong empirical support for PPP suggests that careful policy actions are needed in this region to prevent serious exchange rate misalignment.

Key words: Purchasing power parity, Real exchange rate, Unit root test, Structural breaks, Emerging economies.
JEL: C22, F30, F41.