Title: COINTEGRATION ANALYSIS OF PURCHASING POWER PARITY IN REPUBLIC OF CROATIA
Abstract: Abstract:This paper examines the validity of purchasing power parity (PPP) hypothesis in the Republic of Croatia. The main aim is to test whether the PPP Theory holds in the case of the Republic of Croatia and whether the PPP Theory is an appropriate method on which monetary policy makers can rely in determining the size of the market exchange rate deviations from its long-run value. The PPP Theory in the Republic of Croatia has been tested using methods of cointegration analysis. Two cointegration tests have been applied: Engle-Granger test and ADL test. The existence of the long-run relationship between the price level in the EMU (expressed in Croatian Kuna) and the price level in the Republic of Croatia has been tested using monthly observations of average nominal Croatian Kuna exchange rate against Euro, Consumer Prices Index in the Republic of Croatia (2005=100) and the Harmonised Index of Consumer Prices for the European Monetary Union (2005=100) in the period from January 2000. to December 2012. Based on the Engle-Granger test, it can't be concluded if there is a long-run relationship between the two price levels. The non-existence of the long-run relationship between two price levels has also been confirmed by the ADL cointegration test. Thus, on the basis of the cointegration tests it can be concluded that the PPP hypothesis in the Republic of Croatia has not been confirmed.Keywords: Purchasing power parity theory, Engle-Granger cointegration test, ADL cointegration test.Jel Classification: E31(ProQuest: ... denotes formulae omitted.)INTRODUCTIONIn the case of small open economies, such as Croatian economy, during the globalisation and financial liberalization, the exchange rate plays very important role. Republic of Croatia has so called floating operated exchange rate, which means that exchange rate is formed liberally on exchange market, and Croatian National Bank prevents excessive exchange rate fluctuations and maintains its stability. The outcome of that are frequent arguments about exchange rate overvaluation, and therefore it is very important to establish whether the exchange rate in Republic of Croatia is in accordance with theoretical grounds.Exchange rate has a great significance in economical theory and at the same time it presents important variable of economic politics, and therefore its fluctuations can have great influence on many macroeconomic indicators like prices, interest rates, unemployment, import, export etc.The stability and determined exchange rate level often appear as declarative objects of economic policy. Initial point of measuring exchange rate deviation according to overvaluation or underestimation of domestic currency is the equilibrium exchange rate.The methodology which is offered by purchasing power parity theory provides calculation of equilibrium exchange rate. Purchasing power parity theory is one of the basic theories, which tends to define long-run equilibrium exchange rate and it assumes that in normal terms of free trade, nominal exchange rate is determined on the basis of relationship between domestic and foreign price levels. Therefore parity of purchasing power is exchange rate that equals domestic and foreign price levels.Aim of this paper is to test if purchasing power parity theory is valid in Republic of Croatia and is the purchasing power parity relevant method on witch holders of economic policy can rely during the defining size of market exchange rate deviation from its long-run value.The theory of purchasing power parity in Republic of Croatia is tested by cointegration analysis method. The long run equilibrium exchange rate is formed, based on purchasing power parity theory. Two cointegration tests were conducted, Engle-Granger cointegration test and ADL cointegration test.1. THE PURCHASING POWER PARITY THEORYThe purchasing power parity theory relates exchange rate, domestic price level and foreign price level and it is one of the oldest theories of exchange rate, at the same time it is very important theory of forming exchange rate in international economy. …
Publication Year: 2013
Publication Date: 2013-12-01
Language: en
Type: article
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