Purchasing Power Parity and Degree of Openness in Latin America : A Panel Analysis

We move beyond the all or nothing purchasing power parity (PPP) proposition that has been the norm in previous literature. We test whether inflation, nominal exchange rate volatility, and trade and financial openness influence the stationarity of real exchange rates on a sample of Latin American and Caribbean countries plus Canada during the post Bretton-Woods era. Countries with high inflation and high exchange rate volatility are more likely to support PPP. Classifying the countries by traditional trade openness is not possible to find stationarity consistent with the findings of Alba and Papell (2007) that more open countries are more likely to support PPP. However, when trade openness is parameterized by “relative weight trade intensity” (RWTI), which provides a bi-dimensional approach to international trade weight, we find that higher trade openness leads to higher support of PPP. Westerlund (2007) cointegration error correction model (ECM) tests in panels indicate that financial openness supports PPP only when national debt is not considered. Financially open countries and those that open their borders to trade are more likely to have a mean reversion of exchange rates. These outcomes are relevant to emphasize the benefits of trade and financial openness in economies close to the United States