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Real Exchange Rate Stationarity in Latin America and Relative Purchasing Power Parity: A Regime Switching Approach

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Abstract

This paper tests for long-run purchasing power (PPP) among a sample of six Latin American economies. The key contribution of this paper is in terms of the econometric methodology where non-stationarity of the real exchange rate is tested within a Markov regime-switching framework. In contrast to existing studies, this paper defines two new concepts of PPP where one allows for the possibility that real exchange behaviour either switches between stationary and non-stationary regimes (partial PPP), or switches between stationary regimes characterised by differing degrees of persistence (varied PPP). Whereas standard univariate unit root testing suggests that Latin American real exchange rates are generally non-stationary, employment of the regime-switching methodology indicates that most of the sample is characterised by the existence of two distinct stationary regimes. Further analysis indicates that the high rates of inflation and exchange rate volatility experienced in Latin American have given some impetus towards facilitating long-run PPP.

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Notes

  1. An exception may be productivity shocks as described by Balassa (1964).

  2. Furthermore, Copeland (2000) argues that high inflation penalizes agents for maintaining sticky prices and so attempts to fix the nominal exchange rate may be undermined.

  3. Studies on PPP for developed countries have generally provided ambiguous results without a conclusive answer, for example Balassa (1964) and Hakkio (1984) find evidence in favor of PPP while Dornbusch (1980) and Frenkel (1981) find no evidence in favor of PPP. However, Frenkel (1978) suggests that PPP holds during periods of high inflation.

  4. Mahdavi and Zhou (1994) apply the Johansen technique to investigate PPP in a sample of LDCs using quarterly data for 1973Q2 onwards. They conclude that incidences of PPP are more frequently observed among high inflation countries. Indeed, further evidence on PPP in LDCs based on tests for unit roots and cointegration can be found in Conejo and Shields (1993) and Hoque (1995). While the latter study rejects PPP, Conejo and Shields find evidence in favor of PPP with respect to the US in the cases of Brazil and Mexico.

  5. See Crownover et al. (1996) for an elaboration on this point.

  6. More formally, the volatility of the nominal exchange rate is measured as \( \Omega _{t} = {\left| {e_{t} - e_{{t - 1}} } \right|} \).

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Acknowledgement

I am grateful for the helpful comments and suggestions made by an anonymous referee and the Editor. The usual disclaimer applies.

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  1. Department of Economics, Waikato University Management School, Private Bag 3105, Hamilton, 3240, New Zealand

    Mark J. Holmes

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Correspondence to Mark J. Holmes.

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Holmes, M.J. Real Exchange Rate Stationarity in Latin America and Relative Purchasing Power Parity: A Regime Switching Approach. Open Econ Rev 19, 261–275 (2008). https://doi.org/10.1007/s11079-007-9020-1

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