Is purchasing power parity hypothesis reasonable from the view of trade blocks and currency zones?

Abstract

Since the 1980s, many regional agreements have appeared to facilitate trade and spur economic growth. This paper examines whether or not the purchasing power parity (PPP) hypothesis for regional agreements has been satisfied. This study employs a nonlinear unit root test for real exchange rates (RERs). Overall, the test results provide stronger support for PPP than any earlier studies of bilateral PPP for trade/currency integrated countries. When the data for the postintegration period are included, the evidence for PPP becomes more significant. Regional agreements have promoted the PPP hypothesis. KPSS tests provide more evidence for PPP than the ADF and PP tests for the RERs of European Union (EU) countries against the currency of Germany and the euro but not for the RERs against the US dollar. These results show that convergence toward PPP between the EU countries tends to be nonlinear but is likely to be linear for the non-EU and between EU and non-EU industrialized countries. Tracing back to the potential sources of nonlinearity in RERs proposed in existing literature, the RERs of the EU countries are supposed to be less affected by trade barriers and more by official interventions in the foreign exchange market after the introduction of the euro. Also, financial integration seems to have played a more significant role in recent years over the existence of trade barriers.