Econometric testing of purchasing power parity in less developed countries: fixed and flexible exchange rate regime experiences

We investigate the Purchasing Power Parity (PPP) hypothesis for 16 Less Developed Countries (LDCs), from all over the world, during their fixed and flexible exchange rate experiences over the period 1957:01–1999:12. The main contribution of this article to the empirical literature on PPP is that our study is the first to consider PPP hypothesis on alternative exchange rate regimes for LDCs. The bilateral exchange rates of LDCs and the United States, and their respective price levels are considered. Three different time series methodologies are employed: unit-root tests, Engle–Granger (1987) cointegration technique and Johansen multivariate VAR methodology (1988). The cointegration techniques improve the results, which allows the examination of the more frequent long-run relationship between relative prices and nominal exchange rates. Nevertheless, using each of econometric techniques we find only a few and a nearly equal evidence in favour of PPP under the alternative regimes in LDCs. Hence, the main conclusion of our study is that the deviations from PPP in LDCs cannot be attributed to the exchange rate regime system. Other market regulations should be investigated.