Testing the Purchasing Power Parity Hypothesis for the New Member and Candidate Countries of the European Union: Evidence from Lagrange Multiplier Unit Root Tests with Structural Breaks

This paper investigates the validity of purchasing power parity (PPP) for the eleven Central and East European transition countries and three market economy countries, Cyprus, Malta, and Turkey. Unlike previous studies on PPP, this study uses Lagrange multiplier (LM) unit root tests that incorporate structural breaks in the data series. The findings indicate that in cases of one and two structural breaks, for a U.S. dollar-based real exchange rate series, there is little evidence supporting the validity of PPP. For a deutsche mark-based real exchange rate series, for the cases of both one and two breaks, there is evidence of stationarity of real exchange rates for eight sample countries, which is consistent with PPP. The results also indicate that the estimated half-life of a shock to the real exchange rate ranges from 1.25 (15.05 months) to 2.72 (32.72 months) years across countries. The empirical findings may provide direction for policy makers to coordinate monetary policies for the process of European monetary integration.