International Journal of Economics and Financ ial Issues [606383]

International Journal of Economics and Financ ial Issues
Vol. 3, No. 4 , 2013, pp. 973-976
ISSN: 2146 -4138
www.econjournals.com
973

Purchasing Power Parity in the Case of Romania : Evidence from
Structural Breaks

Oguz OCAL
Nevsehir University, Avanos Vocational School,
Nevsehir , Turkey. Email: [anonimizat]

ABSTRACT: Purchasing Power Parity has most likely been one of t he most investigated issues of the
last decades within economic literature. The results from such studies are not consistent and not only
important for policy makers and economists but also extremely important for policy implications in
international finan ce. Purchasing Power Parity states the exchange rate between two countries should
reflect the relative purchasing power of these two countries. This study tests the validity of the
purchasing power parity hypothesis in Romania with employing Zivot –Andrews unit root test by
taking structural break into account. We use annual data from 1991 to 2012 and the results show that
purchasing power parity does not hold in Romania.

Keywords: Purchasing power parity; real exchange r ates; structural b reaks
JEL Cla ssification s: F30; F31

1. Introduction
Purchasing power parity (PPP here after) is a vital structure block of numerous
macroeconomic models so that the PPP hypothesis is important for policy implications to decision – or
policy makers of central banks, m ultinational firms and exchange rate market participants. Also PPP
has been viewed as an equilibrium condition, as an exchange rate determination theory and as a basis
for international comparison of income (Sideris, 2006).
PPP theory is an important issu e for exchange rate determination in international economics
literature. Theory of P PP is suggests that exchange rates between currencies are in equilibrium when
their purchasing power is the same in each of the two countries (Taylor, 2009) . This means th at
between two currencies exchange rate should be equal to the ratio of the two countries price level of a
fixed basket of goods and services. The basis for PPP is the “law of one price ”.
Early literature on the validity of PPP is voluminous but there is no agreement on the validity
of the PPP yet. For developed countries, it has been extensively tested, but it is abundant in devel oping
countries (Taylor 1988, 2003, 2009 , Taylor and Taylor 2004 ). The other view of these empirical
findings, researchers beli eve that in short run the validity of PPP has uncertainty but they may be more
willing to believe PPP’s validity in the long run , since the price differentials between two countries is
unsustainable in the long -run. Also the PPP hypothesis existing empiric al literature results
inconsistencies can be explained with that past studies indirectly accept that exchange rate behavio ur
is naturally linear.
Generall y most of these studies suggest that the PPP holds in the long -run but the empirical
validity of PPP i n transition economies remains an unsolved issue ( Acaravcı and Ozturk, 2010). The
different types of empirical studies on PPP can be categorised in firstly correlation studies, secon dly
unit root tests studies and thirdly cointegration studies (Acaravci and Acaravci, 2007). Mainly study of
the empirical l iterature which tests the PPP hypothesis for Romania presented at Table 1.

International Journal of Economics and Financial Issues, Vol. 3, No. 4 , 2013, pp. 973-976

974
Table 1. Literature Review for PPP in Romania
Author(s) Method Conclusion
Choudhry (1999) Fractional and Har ris-lnder
cointegration tests No evidence
Christev and Noorbakhsh
(2000) Stock -Watson Dynamic OLS
Johansen cointegration Weak evidence
Barrow and Radulescu (2002) Cointegration analysis No evidence
Barlow (2003) Co-integration analysis Weak evidence
Sideris (2006) Johansen cointegration
Larsson panel cointegration Strong evidence
Solakoglu (2006) Panel approach Strong evidence
Beirne (2007) Johansen co -integration
Larsson panel co -integration Weak evidence
Cuestas (2009) Ng and Perron unit root tests
KSS nonlinear unit root tests Strong evidence
Koukouritakis (2009) Johansen cointegration test Weak evidence
Kasman et al. (2010) LM unit root tests Strong evidence
Acaravcı and Ozturk (2010) ADF unit root tests
KPSS unit root tests Weak evidence
Chang et al. (2011) Nonlinear panel unit root test Strong evidence
Aslan and Kula (2011) Univariate and panel LM unit
root tests Strong evidence

Although the most tested theories in the international economics literature, the empirical
findings for the PPP hypothesis are mixed (Taylor 1988, 2003, 2009). This article aims to investigates
the validity of PPP in Romania for the period 1991 -2012 this long period will differ this study from
previous literature that most of the empirical studies determined that the PPP holds in the long -run.
The following section of the study provi des the analytical framework. Section 2 shows the sources of
the data, methodology and empirical results and in Sections 4 provides conclusions.

2. Analytical Framework
For the strong form of PPP, the nominal excha nge rate is proportional to the relative price so
that the real exchange rate remains constant overtime.
PPNE ERr R*
 (1)
in equation (1); RER is the real exchange rate, rNE is the nominal exchange rate , P* is the foreign
prices and P is the domestic prices .

The real exchange rate can be shown in logarithmic form by equation (2),
) log() log() log() log(*P P NE ERr R   (2)

Equation (3) represents the model of mean r everting real exchange rate :
t tr tR NE ER    1) log( ) log( (3)

in equation (3);  is the constant term,  is the error term. Real exchange rate series should be
stationary for the PPP hypothesis. R eal exchange ra te series stationary means that if there is a change
in the price level between two countries, it will be offset by an equal depreciation/appreciation on the
nominal exchange rate. If there is a unit -root in the real exchange rate, we can say that the real
exchange rate shocks are permanent and there is no PPP between two countries.

Purchasing Power Parity in the Case of Romania; Evidence From Structural Breaks
975
3. Data, Methodology and Empirical Results
Previous literature of PPP stand on the linear unit root tests, but recent studies account for
nonlinearities and/or structural bre aks in real exchange rates. Also the discussion on the validity of
PPP empirical results has no agreement yet. This study will extend the PPP literature by using annual
data that covers the period from 1991 to 2012 and take the US dollar as reference curr ency to construct
the real exchange rates for Romania. The price series are based on the consumer price index and the
nominal exchange rates are the end period spot rates relative to the US dollar (domestic price of th e
US dollar). All data are taken from the International Monetary Fund’s International Financial Statistics
database .
ZA tests models are stated as the following forms:
)6( )( )( : )5( )( : )4( )( :
1
11 2 2 1 11
11 2 1 11
11 2 1 1
t jtk
jj tC
tc
tC C C
tt jtk
jj tB
tA B B
tt jtk
jj tA
tA A A
t
Y Y DT DU t Y C ModelY Y DT t Y B ModelY Y DU t Y A Model
         
    





In the level of the series Model A allows for a change, in the slope of trend of a series Model
B allows for a change w hile Model C combines both changes in the level and the slope of trend.

Table 2. Zivot -Andrews test results
Model type t stat
Model A -3,726
2005
(-4,80)
Model B -3,553
2000
(-4,42)
Model C -3,967
2009
(-5,08)
Note: Critical values at 5% are presented in parenthesis .

Zivot –Andrews test is used to examine whether PPP holds in Romania for a long time by
taking structural break into account. Zivot –Andrews test results are presented in Tab le 2 and test
results suggests that PPP doesn’t hold for Romania .

4. Conclusion
The purpose of this research is to investigate the PPP in Romania because the results of the
previous empirical studies inconsistent . Also PPP has been a great important facto r that to understand
the behaviour of exchange rates for policy makers.
In this study, we apply the Zi vot-Andrews unit root test to re -examines the validity of PPP for
Romania. In Roma nia, the early literature on the validity of PPP has mostly motivated on the use of
unit root tests which disregard structural break. This study is different from the previous literature by
using Zivot –Andrews test with applying exchange rates in Roma nia for the period of 1991 -2012. Our
results show that PPP doesn’t hold in R omania at least for the period of 1991 -2012.

International Journal of Economics and Financial Issues, Vol. 3, No. 4 , 2013, pp. 973-976

976
References
Acaravci, S .K., Acaravci, A. (2007) , Nonstationarity and the level shift for Turkish real exchange
rates. Empirical Economics Letters, 6, 517 -523.
Acara vcı, A., Ozturk, I. (2010), Testing Purchasing Power Parity in Transition Countries: Evidence
from Structural Breaks . Amfiteatru Economic, 12 (27), 290 -298.
Aslan, A. and Kula, F. (2011), Purchasing Power Parity in Eastern European Countries: Further
Eviden ce From Black Market Exchange Rates . Amfiteatru Economic, 13 (29), 287 -294.
Barlow, D. (2003), Purchasing Power Parity in Three Transition Economies . Economics of Planning,
36(3), 201-222.
Barlow, D., Radulescu, R. (2002), Purchasing Power Parity in the Tra nsition: The Case of the
Romanian Leu Against Dollar . Post-Communist Economies, 14(1), 123 -135.
Beirne, J. (2007 ), Purchasing Power Parity in the European Union: A Cointegrated Approach and
Transition Economies. In: European Economics and Finance Society, 6th Annual Meeting of the
EEFS International Conference , Sofia, Bulgaria.
Christev, A., Noorbakshsh, A. (2000), Long -run Purchasing Power Parity, Price and Exchange Rate in
Transition: The Case of Six Central and East European Countries . Global Finance Jou rnal, 11,
87-108.
Chang, H -L. Su, C -W., Zhu, M -N., Liu, P. (2011), Re -examining long -run purchasing power parity for
Central and Eastern European countries: nonlinear panel unit root tests . Applied Economics
Letters, 18 (5), 411 -415.
Choudhry, T. (1999 ). Purchasing power parity in high -inflation Eastern European countries: Evidence
from Fractional and Harris -lnder cointegration tests. Journal of Macroeconomics, 21(2), 293 -308.
Cuestas, J. C. (2009), Purchasing Power Parity in Central and Eastern European Coun tries: An
Analysis of Unit Root and Nonlinearities . Applied Economics Letters, 16(1), 87 -94.
Kasman,S., Kasman, A., Ayhan, D. (2010), Testing the Purchasing Power Parity Hypothesis for the
New Member and Candidate Countries of the European Union: Evidence from Lagrange
Multiplier Unit Root Tests with Structural Breaks, Emerging Markets Finance & Trade / 46 (2),
53–65.
Koukouritakis, M. (2009) , Testing the purchasing power parity: evidence from the New EU countri es.
Applied Economics Letters, 16(1), 39–44.
Sideris, D. (2006), Purchasing Power Parity in Economies in Transition: Evidence from Central and
East European Countries . Applied Financial Economics, 16(1 -2), 135 -143.
Solakoglu, E .G. (2006) , Testing purchasing power parity hypothesis for transition economies . Applied
Financial Economics, 16, 561 –568.
Taylor, M .P. (1988) , An empirical examination of long -run purchasing power parity using
cointegration techniques. Applied Economics, 20, 1369 –1381.
Taylor, M .P. (2003) , Purchasing Power Parity . Review of International Economics, 11(3), 436-452.
Taylor A. M., Taylor M.P. (2004) , The Purchasing Power Parity Debate . Journal of Economic
Perspectives, 18(4), 135 –158.
Taylor, M .P. (2009) , Long -run purch asing power parity and real exchange r ates: introduction and
overview. Applied Economics Letters, 16, 1–4.
Zivot, E., Andrews, D. (1992) , Further evidence on the great crash, the oil price shock, and the unit
root hypothesis. Journal of Business and Econom ic Statistics, 10(3), 251 – 270.