The validity of purchasing power parity hypothesis for eleven middle eastern countries

Abstract

There is a large literature that examines purchasing power parity (PPP). The growth in this literature is mainly due to the absence of a consensus view on whether or not PPP holds. This paper considers PPP for 11 Middle Eastern countries using a number of tests: the one-break test unit root, the two-breaks unit root test, and the panel Lagrange multiplier (LM) unit root test with structural breaks. The main finding from univariate tests is that there is evidence for PPP in only seven countries (Lebanon, Saudi Arabia, Egypt, Iran, Syria, Tunisia and Sudan). However, when the panel LM test is applied with two structural breaks, strong evidence is found in favor of PPP for the Middle Eastern countries.

Keywords:

• Purchasing power parity
• Middle Eastern countries
• JEL CLASSIFICATION: F31
• F41

Notes

 Arguing in favor of using a time trend in testing for a unit root in real exchange rates, Shively (2001: 202) states that ‘rejection of the random walk hypothesis in favour of the trend stationary alternative is evidence that the real exchange rate returns to a long-run equilibrium and therefore evidence in favour of a true long-run purchasing power parity relationship’. For further importance of incorporating a time trend in the model, see Marcela (2003).