Does purchasing power parity hold between European countries? : investigation using non-linear STAR model

• Author(s): Zhang, Kai
• Date: 2012
• Persistent ID: http://hdl.handle.net/10400.14/15429
• Origin: Veritati - Repositório Institucional da Universidade Católica Portuguesa
• Subject(s): Purchasing power parity; Unit roots; Non-linearity; Euro area; Exponential smooth transition autoregressive model; Domínio/Área Científica::Ciências Sociais::Economia e Gestão
• Document Type: Master thesis
• Language: English
• Advisor(s): Pavlidis, Efthymios
• Contributor(s): Veritati - Repositório Institucional da Universidade Católica Portuguesa

Description

This paper investigates whether purchasing power parity (PPP) holds or not between each European country. PPP is a fundamental building block of international economics. The research of PPP not only can help economist understand exchange rate behaviour, but also assist with monetary maker to establish sensible exchange rate policies. For examining the PPP validity in euro, this paper starts at a general introduction of the exchange rate importance. The following is an in-depth overview of PPP studies and econometric technique developments since 1970s. We applied the non-linear Exponential Smooth Transition Autoregressive (ESTAR) for a new test (KSS test) and ADF test to the real exchange rates between 9 European countries. The results demonstrate the new test giving more support to PPP than that of ADF test. And while the linear ADF test can only reject a unit root in 6 cases, the new test is able to reject in 13 cases out of 36, which are in favour of PPP and offer evidences of non-linear mean reversion in real exchange rate.