Purchasing power parity in transition countries: Sequential panel selection method

a r t i c l e i n f o JEL Classification: C22 F31 Keywords: Purchasing power parity Real effective exchange rate Transition countries Sequential Panel Selection Method Panel KSS unit root test Fourier function Policy implications This study applies the Sequential Panel Selection Method (SPSM), proposed by Chortareas and Kapetanios (2009) to test the validity of long-run purchasing power parity (PPP) for a sample of 14 transition countries, using real effective exchange rates, from 1994 to 2012 (for both monthly and quarterly data). SPSM classifies the whole panel into a group of stationary series and a group of non-stationary series. In doing so, we can clearly identify how many and which series in the panel are stationary processes. Empirical results from the SPSM using the Panel KSS unit root test (Ucar and Omay, 2009) with a Fourier function indicate that PPP holds true for most of these transition countries studied. Our results have important policy implications for these transition countries under study. During much of the past several decades, a huge number of studies have centered on the investigation of the stationarity of the real ex-1 Not only are the results from studies in this regard critical for both empirical researchers and policymakers alike but also have extremely important implications in international finance. To be more specific to the point, a non-stationary real exchange rate indicates that any long-run relationship between the nominal exchange rate and domestic and foreign prices is virtually non-existent, therefore invalidating the theory of purchasing power parity (hereafter, PPP). In this event, PPP cannot be used to determine the equilibrium exchange rate; what's more, the invalidation of PPP disqualifies any monetary approach to determine the exchange rate since that would necessitate that PPP holds true. Granted that numerous studies have found support a unit root in real exchange rates, but critics have staunchly contended that the drawing such a conclusion may be attributed to the lower power of the conventional unit root tests employed when compared with near-unit-root but stationary alternatives. More than that, conventional unit root tests have reportedly failed to consider information across regions, thereby yielding less efficient estimations. It should therefore not be unexpected that these shortcomings have seriously called into questions many of the earlier findings which are based on a unit root in real exchange rates. In this regards, the first generation panel-based unit root tests—Levin–Lin–Chu (Levin et al., …