17/04/2007
Testing the Purchasing Power Parity: Evidence from the New EU Countries

Testing the Purchasing Power Parity: Evidence from the New EU Countries

This paper examines the validity of the purchasing power parity between each of the twelve new EU countries vis-à-vis the Eurozone.

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On May 1, 2004, the EU has experienced its biggest expansion ever in terms of scope and diversity. Ten countries, namely Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic and Slovenia, joined the Union. On January 1, 2007, Bulgaria and Romania also joined the EU. In order to successfully join the EU these countries had to satisfy certain economic and political criteria, which include being stable democracies, respect human rights as well as having a functioning market economy.

Except for Malta and Cyprus, all the above former centrally planned economies faced many challenges during the pre-EU accession period. In the late 1990s, most of them pegged their currencies to the euro in order to strengthen their case for the EU accession. Most of these countries have already become members of the Exchange Rate Mechanism (ERM) II and plan to apply for Eurozone membership in the near future1. On the other hand, most of these countries are still facing serious inflation problems. These features provide an interesting research field of the purchasing power parity (PPP) for these countries.

The validity of the PPP has been extensively tested, especially for developed countries (see for example Froot and Rogoff (1995), Frankel and Rose (1996), Lothian and Taylor (1997, 2000)). In general, these studies concluded that the PPP holds in the long-run. For the transition economies, the validity of the PPP has been tested by Thacker (1995) and Solakoglu (2006). The former study uses a cointegration approach and rejects the PPP hypothesis for Hungary and Poland, while the latter one, which uses a panel approach, concludes that the PPP holds for the transition economies.

In this paper I use the most recent data available from the mid-1990s to the present and the Johansen et al. (2000) cointegration methodology in the presence of structural breaks, to test the PPP hypothesis for the twelve new EU countries. I also test the symmetry and proportionality restrictions implied by the long-run PPP. In brief, the evidence suggests that even though the nominal exchange rate, the domestic prices and the foreign prices are cointegrated for all the new EU countries, the long-run PPP hypothesis holds only for Bulgaria, Cyprus, Romania and Slovenia. 

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