Academic journal article International Journal of Business and Society

The Validity of Purchasing Power Parity (PPP) Theory in Asean-Five Economies: The Bounds Test Approach

Academic journal article International Journal of Business and Society

The Validity of Purchasing Power Parity (PPP) Theory in Asean-Five Economies: The Bounds Test Approach

Article excerpt

ABSTRACT

This study aims to examine the robustness of different Purchasing Power Parity (PPP) models by applying different types of econometric techniques for the ASEAN-Five economies from 1983:M1 to 2002:M9. Two versions of the PPP models have been estimated using the Engle-Granger (EG) two-step cointegration test, the Johansen-Juselius (JJ) multivariate cointegration procedure and the bounds testing approach (or bounds test) proposed by Pesaran et al. (2001). Based on the EG and the JJ multivariate cointegration tests, we found that the absolute PPP model does not hold in the countries under investigation, while the financial data of the five ASEAN countries supported the validity of the relative PPP model when the JJ cointegration procedure were applied. The validity of the relative purchasing power parity was also supported when the bounds test was used in the analysis. Therefore, this study can be viewed as an additional work in providing justification for the theory of PPP in ASEAN-Five economies.

Keywords: Purchasing power parity; Cointegration tests; ASEAN-5.

I. INTRODUCTION

Since the pioneering work of Cassel in the early 190Os, the Purchasing Power Parity (PPP) theory has been subjected to great controversy. The parity reveals that prices in two different countries should be identical when they are expressed in terms of the same currency. PPP has attracted much attention from the monetary economists because it can be viewed as a cornerstone of the monetary model in determining the exchange rate behaviour (Dornbusch, 1976).

Theoretically, the PPP theory is a long run model in determining the equilibrium exchange rate. Hence, the relationship might deviate in the short-run. A number of previous studies found evidence against the robustness of the parity in the short-run (Dornbusch, 1976; Frenkel, 1978). Although it is widely accepted that the parity is valid in the long-run, the findings of the literature are mixed. For example, Baillie and Selover (1987), Abuaf and Jorian (1990), and Kim (1990) provided evidence to support the hypothesis of PPP in the long-run, while Meese and Singleton ( 1982) and Cooper ( 1994) have rejected the hypothesis.

The controversy of PPP theory has arisen mainly because of the data-generating process of the variables concerned. In their studies, Meese and Singleton (1982) found that nominal exchange rate has a unit root. This means that the series follows a random walk process and its movement is unpredictable. In other words, the level relationship of the series concerned would not be confirmed in both the short and long-run. Since then, the unit root tests such as the Dickey-Fuller (DF) test, Augmented Dickey-Fuller (ADF) test, Phillips-Perron (PP) test and the Bayesian unit root approaches have been applied to examine the robustness of the PPP theory. For example, Manzur and Ariff ( 1995) examined the presence of the PPP for the Group Seven and ASEAN countries. The hypothesis of unit root for these countries failed to be rejected when DF, ADF and PP tests were used. However, they found evidence that support the view that the exchange rate does not follow a random walk when they applied the Sim's test. As a result, they concluded that there exists a long-run relationship between exchange rate and the price ratio for these economies. Similar conclusion was drawn from Whitt (1992) by applying similar test, using monthly data.

Resulting from the weaknesses of the traditional unit root tests, more and more researchers have been testing the validity of PPP hypothesis by applying the traditional ADF tests within panel approaches and provide mixed evidence. Using the Levin and Lin ( 1993) method, Oh (1996), Wu (1996), Papell (1997) and Lothian (1997) found that real exchange rates follow stationary process during the floating exchange rate period in OECD economies. Wu ( 1996) estimated the speed of adjustment to be within 2.5 to 3 years using both the consumer price index and World price index for monthly, quarterly and annual data. …

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