Purchasing Power Parity hypothesis does not hold in the short-run because prices adjust very slowly. Hence, the empirical literature is focused on whether this hypothesis is valid in the long-run, i.e. when prices become flexible. When PPP among developed countries is examined, the main task is the speed of adjustment toward equilibrium. However, many researchers have found evidence of convergence to PPP in the long run with high measures of “half-life” - 3 to 5 years – (see for example, Rogoff, 1996 and Obstfeld & Rogoff, 2000).
Recently, there is an increasing interest in PPP hypothesis for developing countries. Some studies apply univariate unit root tests on real exchange rates, while others apply more powerful panel unit root tests. For example, Bahmani-Oskooee (2000) employ a KPSS test on real effective exchange rates of 20 developing countries and find supportive evidence against PPP. Alba & Park (2003) by employing a panel unit root test (Levin et al, 2002) on 15 developed and 65 developing countries find that PPP is more easily accepted for more open; high inflation and low-growth economies. In line with this finding, Holmes (2000) shows that PPP is strongly accepted for high inflation but rejected for low inflation countries. Using a similar methodology for 88 developing countries, Oh (1996) finds supporting evidence of PPP when the whole period (1950- 1990) is examined. In contrast, when this period is split into fixed and flexible exchange rate regimes, PPP cannot be accepted.
Some researchers apply univariate (Engle-Granger, 1987); multivariate (Johansen, 1988) and panel cointegration techniques on the relationship between nominal exchange rates and relative prices. Mahdavi & Zhou (1994) find evidence of weak-form PPP in 8 out of the 13 developing countries and state that stronger evidence exists in relatively high inflation countries. Similarly, Salehizadeh & Taylor (1999) confirm weak-from PPP for 27 developing countries (exchange rates per US dollar). Moreover, Nagayasu (1998) and Boyd & Smith (1998) support PPP in developing countries by employing panel cointegration tests. On the other hand, Drine & Rault (2003) and Basher & Mohsin (2004) fail to confirm PPP in developing countries by panel cointegration tests. The former study shows that while the exchange rate regime does not matter, PPP is more possible to hold in high inflation countries.
Others examine the validity of PPP hypothesis under the presence of structural breaks. Aggarwal et al (2000) and Sabate et al (2003) apply univariate unit root tests with structural breaks and find supporting evidence of PPP for 7 Asian currencies against Japanese Yen and the peseta-sterling exchange rate, respectively. In contrast, Payne et al (2005) cannot establish PPP hypothesis in the case of Croatia by modeling two breaks in unit root tests. Besides to unit root tests, Zurbruegg & Allsopp (2004) apply multivariate cointegration techniques, by allowing the presence of structural breaks, to test PPP in Asian countries in a period including the financial crisis (1997). They conclude that under the presence of significant structural breaks, PPP is found to be a valid long run relationship in 5 out of the 8 countries. In line with the presence of structural breaks, some studies show that convergence to PPP equilibrium may be a non-linear instead of a linear mean reverting process. Indeed, this is confirmed by Sarno (2000) for 11 Middle Eastern countries and by Liew (2003) for Asian developing countries.
The present study concentrates on four Central & Eastern European Countries (Czech Republic; Hungary; Poland and Slovak Republic), which recently became the new country-members of EU. The purpose of this paper is twofold. Firstly, we seek whether PPP is a valid long run relationship in the case of these developing countries. Secondly, we attempt to define those countries’ trade linkages between Euro Area; US and the rest of the world. For this reason we examine 3 types of exchange rates. For each country, we estimate 2 bilateral exchange rates (against EURO and US dollar) and the effective exchange rate. In other words, this paper contributes on understanding whether PPP holds as a groundwork of equilibrium exchange rate. Namely, in line with their entry into EU, we expect strong trade linkages with former EU country-members. By establishing PPP hypothesis we can argue that these trade relations exist, indicating no trade frictions and other barriers. Therefore, a normal entry into EMU requires PPP to be valid between these countries and former EU members.