International Journal of Economics and Financial Issues Vol. 2, No. 3, 2012, pp ISSN:

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1 Inernaional Journal of Economics and Financial Issues Vol. 2, No. 3, 2012, pp ISSN: The Impac of Srucural Break(s) on he Validiy of Purchasing Power Pariy in Turkey: Evidence from Zivo-Andrews and Lagrange Muliplier Uni Roo Tess Hakan Kum Nevsehir Universiy, Faculy of Economics and Adminisraive Sciences, Deparmen of Economics, Nevsehir, Turkey. ABSTRACT: This sudy examines he validiy of he purchasing power pariy (PPP) in Turkey for annual daa from 1953 o While resuls from boh he ADF uni roo and he DF-GLS uni roo es indicae mixed resuls, PPP holds for Turkey wih he presence of srucural breaks which are obained by Zivo and Andrews and Lagrange Muliplier uni roo ess. Keywords: Purchasing power pariy; PPP; Srucural Breaks; Turkish Economy. JEL Classificaions: C22; F31 1. Inroducion The purchasing power pariy (PPP) heory has been one of he more conroversial opics in inernaional macro economics given ha is empirical validiy is sill subjec o examinaion. The heory, which is a generalizaion of he law of one price, assumes ha all goods are idenical and ransporaion coss and rade barriers are very low in boh counries. The absolue version of he heory assers ha under hese condiions, he same baske of goods and services should cos he same when expressed in erms of he same currency. In order o invesigae he validiy of PPP, uni roo esing has become a very popular approach. If he real exchange rae includes a uni roo, he shocks should have permanen effecs and he variable will never reurn o is long run equilibrium. On he oher hand, if he real exchange rae is saionary, shocks end o die ou in he long run and he equilibrium is achieved some ime afer he shock has occurred (Cuesas and Regis, 2008). The validiy of PPP is significan o policymakers for wo moivaions. One of hem is ha PPP can be used o forecas exchange rae o conclude wheher a currency is overvalued or undervalued. Wheher a currency is over or undervalued is mainly significan for especially developing counries and also for hose experiencing large differences beween domesic and foreign inflaion raes. The oher moivaion is he noion of PPP which is used as he foundaion on which many heories of exchange rae deerminaion are buil. Therefore, he validiy is imporan o hose policymakers in developing counries who base heir adjusmen on he PPP (Chang e al., 2010). While he validiy of PPP is imporan for developing counries, empirical evidence for developing counries mixed (Telaar and Kazdaglı, 1998; Bahmani-Oskooee and Mirzai, 2000; Tasan, 2005; Kalyoncu, 2009). These mixed resuls can be due o he use of ADF ype models ha hey do no allow researchers o model he impac of srucural changes in he economy. These srucural changes, which could be a resul of shocks, do impac macroeconomic variables. I follows ha failure o incorporae srucural changes in esing for he uni roo propery of macroeconomic variables is likely o proffer spurious conclusions (Narayan, 2006). Exchange raes ha migh be affeced by inernal or exernal shocks caused by srucural changes may be subjec o subsanial shor-run variaion. I is significan o know wheher or no he real exchange rae has any endency o sele down o a long-run equilibrium level, as PPP hypohesis requires ha real exchange rae evolves around a consan or a ime rend. If real exchange rae is found saionary by using uni roo es wih srucural break(s), he effecs of shocks such as real and moneary shocks ha cause deviaions around a mean value or deerminisic rend are only emporary (Yavuz, 2009).

2 Inernaional Journal of Economics and Financial Issues, Vol. 2, No. 3, 2012, pp The aim of his paper is o invesigae PPP for Turkey and he period of analysis is se from 1953 o For his purpose, we employ ADF and DF-GLS ess. In order o es he uni roo hypohesis aking ino accoun he possibiliy of srucural breaks in he daa, we perform he Zivo and Andrews and Lagrange Muliplier (LM) uni roo ess developed by Lee and Srazicich (2004). The purpose is o show ha how sensiive our resuls are o srucural changes. Unlike previous sudies, we focus one and wo srucural breaks wih he larges daa se for Turkey. The paper is organized as follows. In Secion 2, we describe he daase and mehodology. In Secion 3, we presen empirical resuls he ime series. The main conclusions of he analysis are summarized in Secion Daa and Mehodology * P RER NER (1) P Where RER is he real exchange rae, NER is he nominal exchange rae and P* and P are he foreign and domesic prices, respecively. In logarihmic form, he real exchange rae can be represened by * log( RER) log( NER) log( P ) log( P) Following equaion shows he model of mean revering real exchange rae log( RER) log( RER) 1 (3) Where and are consan and error erm respecively. PPP sugges ha real exchange rae series should be saionary. If real exchange rae is saionary his exhibi ha any percenage changes in he price level beween wo counries would be offse by an equal depreciaion/appreciaion of he nominal exchange rae. If here is a uni-roo in he real exchange rae his implies ha shocks o he real exchange rae are permanen and PPP does no exis beween wo counries. Figure 1. Turkey Real Exchange Rae for he period of E+09 (2) 4.0E E E E E RER Exchange raes and price levels are aken from he Inernaional Moneary Fund s Inernaional Financial Saisics (IMF-IFS) daabase and are defined as he logarihm of he price raio generaed by Turkey consumer price index (CPI) divided by he US CPI.

3 The Impac of Srucural Break(s) on he Validiy of Purchasing Power Pariy in Turkey: Evidence from Zivo-Andrews and Lagrange Muliplier Uni Roo Tess Empirical Resuls We sar o apply ADF o es validiy of PPP and o achieve an increase in power of he sandard ADF es; we also apply is varian es proposed by Ellio e al. (1996), he DF-GLS es. ADF and DF-GLS es resuls are presened in Table 1. While ADF es wih rend suppor he validiy of PPP, DF-GLS does no confirm he validiy of PPP. Perron (1989) shows ha failure o allow for an exising breaks leads o a bias ha reduces he abiliy o rejec a false uni roo null hypohesis. To overcome his problem, he auhor proposes allowing for a known or exogenous srucural break in he Augmened Dickey-Fuller (ADF) ess. Table 1. Augmened-Dickey-Fuller and Dickey-Fuller GLS Augmened Dickey-Fuller es saisic Ellio-Rohenberg-Sock DF-GLS es saisic Noe: Opimal lag selecion is based on SIC. Wihou rend (3) [ ] (3) [ ] Wih rend (0) [ ] (3) [ ] Following his developmen, many auhors, including Zivo and Andrews (1992) and Perron (1997) proposed deermining he break poin endogenously from he daa. In addiion o ADF and DF-GLS es, wo uni roo ess wih srucural breaks, namely he Zivo-Andrews (1992) and Lagrange Muliplier (LM) uni roo ess wih one and wo srucural breaks (Lee and Srazicich 2004) are employed in his aricle. The Zivo and Andrews es adops an endogenous sequenial es ha uses differen dummy variables o idenify each possible break in he full sample (Table 2). Table 2. Zivo-Andrews Uni Roo Tes Inercep Trend Boh k Min TB K Min TB k Min TB Criical values inercep: (1%), (5%); rend: (1%), (5%); boh: (1%), (5%) The Zivo and Andrews es was employed o es he saionariy of he variables wih one srucural break by selecing opimal lag via -es. On he oher hand, Zivo and Andrews es was criicized for is reamen of breaks under he null hypohesis. Given he breaks were absen under he null hypohesis of uni roo here may be endency for hese ess o sugges evidence of saionariy wih breaks (Lee and Srazicich, 2003). Lee and Srazicich (2003) propose a wo break minimum Lagrange Muliplier (LM) uni roo es in which he alernaive hypohesis unambiguously implies he series is rend saionary (Glyyn e al, 2007). To avoid problems of bias and spurious rejecions, he endogenous break LM uni roo es derived in Lee and Srazicich (2003) is employed in PPP esing. In conras o he ADF-ype ess, size properies of he break LM es are unaffeced by breaks under he null (Table 3). The break minimum LM uni roo can be described as follows. According o he LM principle, a uni roo es saisic can be obained from he following regression: ri Z S 1 (4) Here, is he firs difference operaor; S r ˆ Z ˆ = 2,..T; ˆ are coefficiens in he regression of r on Z ; ˆ x is given by r Z. If real exchange rae has a uni roo for counry i hen = 0, which is he null hypohesis esed using he -es agains he alernaive hypohesis ha < 0. The panel LM es saisic is obained by averaging he opimal univariae LM uni roo -es saisic esimaed for each counry. x

4 Inernaional Journal of Economics and Financial Issues, Vol. 2, No. 3, 2012, pp This is denoed as LM i LM 1 N N barnt LM i i 1 (5) Table 3. Lagrange Muliplier (LM) uni roo ess Wihou srucural break One Break Two Breaks * (8) *** (8) [2000] *** (8) [1989, 1997] The 1, 5 and 10% criical values for he LM es wihou a break are 3.63, 3.06, 2.77; one break criical values for he LM es saisic from Lee and Srazicich (2004) a he 10%, 5% and 1% significance levels are , , *,**and *** denoe saisical significance a he 10%, 5% and 1% levels respecively. The 1, 5 and 10% criical values for he minimum LM es wih wo breaks are 4.545, and 3.504, respecively. Overall resuls, we concluded ha PPP is valid for Turkey for he larges period from The oucome of he break daes has some imporan ools for PPP hypohesis. For example, The Eas Asian currency crisis (1997) forced many economies in he region o shif away from de faco dollar-pegged regimes o more flexible exchange rae regimes. The dollar had played a dominan role as an inernaional anchor currency unil he oubreak of he crisis in he summer of In addiion, Turkey experienced severe financial crises in 1994 and 2000 which affec Turkey exchange rae. 4. Conclusion The analysis of PPP has probably been one of he mos conroversial opics of he las decades wihin macro economics. This paper invesigaes he impac of srucural break on he validiy Purchasing Power Pariy in Turkey. We concluded ha while uni roo es wihou srucural break illusrae mixed resuls, PPP holds for Turkey wih he presence of srucural breaks which are 1997 (Asian crisis), 1994 and 2000 (financial crises in Turkey). References Bahmani-Oskooee, M., Mirzai, A., (2000), Real and nominal effecive exchange raes for developing counries: 1973:1-1997:3. Applied Economics, 32, Chang, T., Tang, D., Liu, W., Lee, C., (2010), Purchasing power pariy for 15 COMESA and SADC counries: Evidence based on panel SURADF ess. Applied Economics Leers, 17, Cuesas, J.C., Regis, P.J., (2008), Tesing for PPP in Ausralia: Evidence from uni roo es agains nonlinear rend saionariy alernaives. Economics Bullein, 3, 1-8. Elio, G., Rohenberg, T., Sock, J., (1996), Efficien ess for an auoregressive Uni Roo, Economerica, 64, Glyyn, J., Nelson, P., Reeu V., (2007), Uni roo ess and srucural breaks: A survey wih applicaions. Journal of Quaniaive Mehods for Economics and Business Adminisraion, 3, Kalyoncu, H., (2009), New evidence of he validiy of purchasing power pariy from Turkey. Applied Economics Leers, 16, Lee, J., Srazicich, M., (2003), Minimum LM uni roo es wih wo srucural breaks. Review of Economics and Saisics, 85, Lee, J., Srazicich, M.C., (2004), Minimum LM Uni roo es wih one srucural break, Working Paper, Deparmen of Economics, Appalachain Sae Universiy. Narayan, P.K., (2006), Are bilaeral real exchange raes saionary? Evidence from Lagrange Muliplier uni roo ess for India. Applied Economics, 38, Perron, P., (1989), The grea crash, he oil price shock, and he uni roo hypohesis. Economerica, 57, Perron, P., (1997), Furher evidence on breaking rend funcions in macroeconomic variables. Journal of Economerics, 80,

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