Revisiting Purchasing Power Parity in Eastern European Countries: Quantile Unit Root Tests

Revisiting purchasing power parity in
Eastern European countries: quantile unit

root tests
Mohsen Bahmani-Oskooee, Tsangyao

Chang, Tsung-Hsien Chen & Han-Wen
Tzeng
Empirical Economics
Journal of the Institute for Advanced
Studies, Vienna, Austria
ISSN 0377-7332
Empir Econ
DOI 10.1007/s00181-016-1099-z
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Author's personal copy
Empir Econ
DOI 10.1007/s00181-016-1099-z
Revisiting purchasing power parity in Eastern

European countries: quantile unit root tests
Mohsen Bahmani-Oskooee1 · Tsangyao Chang2 ·

Tsung-Hsien Chen3 · Han-Wen Tzeng4
Received: 28 June 2015 / Accepted: 6 April 2016

© Springer-Verlag Berlin Heidelberg 2016
Abstract This study applies quantile unit root test proposed by Koenker and Xiao (J
Am Stat Assoc 99(467):775–787, 2004) and Galvao (J Econom 152:165–178, 2009) to
revisit the purchasing power parity in 7 transition countries: Bulgaria, Czech Republic,
Hungary, Lithuania, Poland, Romania, and Russia over 1998M1 to 2015M3. While
traditional unit root tests fail to reject unit root hypothesis, the two quantile unit root
tests did reject unit root null hypothesis in all countries, providing support for the PPP
and solving the PPP puzzle. The estimated half-life based on quantile autoregressive
model is about 12–25 months (1–2 year).
Keywords Purchasing power parity · Quantile unit root test · Transition countries
Valuable comments of two anonymous referees are very much appreciated. Remaining errors, however,
are our own.
B Mohsen Bahmani-Oskooee
bahmani@uwm.edu
Tsangyao Chang
tychang@mail.fcu.edu.tw
Tsung-Hsien Chen
cheng523@cyut.edu.tw
Han-Wen Tzeng
hann@ocu.edu.tw
1 The Center for Research on International Economics and Department of Economics, University
of Wisconsin-Milwaukee, Milwaukee, WI, USA
2 Department of Finance, Feng Chia University, Taichung, Taiwan
3 Department of Insurance, Chaoyang University of Technology, Taichung, Taiwan
4 Department of Finance, Overseas Chinese University, Taichung, Taiwan
123
M. Bahmani-Oskooee et al.
JEL Classification C22 · F31
1 Introduction
Purchasing power parity (hereafter, PPP) remains an interesting research topic in

international macroeconomics. Validating the PPP is critical not only for empirical
researchers but also for policymakers. PPP states that due to arbitrage activities in the
international commodities market, the real exchange rates that combine the move-
ments of relative prices with nominal exchange rates are expected to return to a
constant equilibrium value in the long run. This means real exchange rate will be
a mean-reverting process—stationary in the long run. In particular, a non-stationary
real exchange rate indicates that there is no long-run relationship between nominal
exchange rate and domestic and foreign prices, thereby invalidating the PPP hypothesis
(Lin et al. 2011). As such, PPP cannot be used to determine the equilibrium exchange
rate, and an invalid PPP also disqualifies the monetary approach to exchange rate deter-
mination, which requires PPP to hold true. Empirical evidence on the stationarity of real
exchange rates is abundant but inconclusive thus far. Previous studies by MacDonald
and Taylor (1992), Taylor (1995), Taylor (2006), Peel and Venetis (2003), Lothian and
Taylor (2000), Sarno and Taylor (2002), Taylor and Taylor (2004), Sjolander (2007),
Bahmani-Oskooee et al. (2008), Bahmani-Oskooee and Hegerty (2009), Chang and
Tzeng (2013), He and Chang (2013), He et al. (2014) and Bahmani-Oskooee et al.
(2014)have provided in-depth information on its theoretical and empirical aspects.
However, the above tests usually focus on the average behavior of real exchange
rate without considering the influence of various sizes of shocks on real exchange rate.
In other words, the speed of adjustment in real exchange rate toward its equilibrium
is usually assumed to be constant, no matter how big or what sign the shock is. As a
result, the commonly used conventional unit root tests possibly lead to a widespread
failure in the rejection of unit root null hypothesis in real exchange rates. This paper
intends to deal with the above deficiency by employing two newly developed quantile
unit root tests by Koenker and Xiao (2004) and quantile unit root test with stationary
covariates by Galvao (2009) to enhance estimation accuracy.
In this study, we use quantile unit root tests to reinvestigate validity of the PPP in
seven transition countries of Bulgaria, Czech Republic, Hungary, Lithuania, Poland,
Romania, and Russia over 1998M1 to 2015M3. According to Hosseinkouchack and
Wolters (2013), there are several advantages of these new tests. First, a quantile-based
unit root test can allow for the possibility that shocks of different sign and magnitude
to have different impacts on real exchange rate. Second, this approach is not restricted
to a specific number of regimes. Indeed, it allows generally for differences in the
transmission of all kinds of different shocks. Third, the tests avoid the estimation of
additional regime parameters and therefore reduces estimation uncertainty. Fourth, the
tests have higher powers than conventional unit root tests as shown by Koenker and
Xiao (2004). Finally, the quantile-based unit root test is superior to standard unit root
tests in case of departure from Gaussian residuals
The transition countries in our sample have recently moved from centrally planned
economies toward market-driven economies that motivate us to investigate the behav-
123
Revisiting purchasing power parity in Eastern European…
ior of real exchange rate. Determining the behavior of exchange rates in such countries
would provide information not only to policy makers in developing sound exchange
rate and monetary policies but also to traders and global investors in their trade and
investment strategies. Even though a number of studies have tested the PPP hypothesis
in the transition economies (see, among others, Baharumshah and Borsic 2008; Lin
et al. 2011; Solakoglu 2006; Cuestas 2009; Telatar and Hasanov 2009), this study
differs from those studies by applying the quantile-based unit root tests for the first
time. The remainder of this paper is organized as follows. Section 2 presents the data
used in our study. Section 3 first briefly describes the quantile unit root tests proposed
by Koenker and Xiao (2004) and Galvao (2009). Empirical results in support of PPP
are reported in Sect. 4. Finally, a summary and conclusion appears in Sect. 5.
2 Data
This empirical analysis covers seven transition countries: Bulgaria, the Czech Repub-
lic, Hungary, Lithuania, Poland, Romanian, and Russia. We employ monthly data in
our empirical study, and the time span is from January 1998 to March 2015.1 Due to
data availability, our study can only focus on these seven transition countries. Some
transition countries are excluded because they joined the European community and no
longer have its own currency such as Estonia and Latvia. All consumer price indices,
CPI (based on 2000 = 100), and nominal exchange rates relative to the USA dollar
data, respectively, are taken from the Datastream. Each of the consumer price index
and nominal exchange rate series was transformed into natural logarithms before per-
forming the econometric analysis. Testing for the PPP against the USA is based on
the argument that internal foreign exchange markets are mostly dollar dominated. In
addition, funds for economic reconstructions are being provided by US-sponsored
institutions (Bahmani-Oskoee et al. 2015).
We define the bilateral real exchange rate, RE, as:

P∗
REt = NEt (1)
P t
where NEt is the nominal exchange rate defined as number of units of local currency
per US dollar; Pt and Pt∗ are the domestic and US price levels, respectively, measured
by consumer price indices (CPI). Taking log from both sides of (1) and denoting the
log of each variable by small letter corresponding to that variable yield:
ret = net + pt∗ − Pt (2)
From a statistical point of view, the validity of the purchasing power parity (PPP)
hypothesis reduces to a unit root test of ret . The presence of a unit root in the real
1 The period prior to 1998 was eliminated from the analysis because changes in overall inflation during
the early years of the transition process (especially appreciation of the real exchange rate) were dominated
by firm-level restructuring involving massive lay-offs, the adjustment of distorted relative prices from the
Communist era and pegged exchange rate regimes motivated by concerns for macroeconomic stabilization.
123
Table 1 Summary statistics of real exchange rate
Bulgaria Czech Hungary Lithuania Poland Romanian Russia
Mean −2.695402 3.407058 3.927358 1.919865 1.576201 1.666739 3.315126

Median −2.740203 3.352193 3.858835 1.895301 1.539342 1.780723 3.242040
Maximum −2.180030 3.949979 4.439596 2.246229 1.915200 2.259344 3.958503
Minimum −3.091108 2.936943 3.480149 1.603565 1.127907 0.210172 2.874580
SD 0.284944 0.273464 0.238043 0.210025 0.174235 0.441420 0.343416
Skewness 0.383448 0.359096 0.473229 0.283116 −0.113267 −1.785139 0.485502
Kurtosis 1.635511 1.838082 2.030560 1.596982 2.261174 5.767393 1.826913
Jarque–Bera 21.13089 16.09299 15.83202 19.74329 5.150695 175.9961 20.00121
Probability 0.000026 0.000320 0.000365 0.000052 0.076127 0.000000 0.000045
Observations 207 207 207 207 207 207 207
exchange rate series would imply that PPP does not hold in the long run. If PPP holds,
it implies that nominal exchange rate is corrected for inflation differentials, as shown
by (2). Chang et al. (2011) note that non-stationarity in real exchange rates has many
macroeconomic implications. For example, Dornbusch (1987) has argued that if real
exchange rate depreciates, it could bring a gain in international competitiveness, which
in turn could shift the employment toward the country whose currency depreciates.
Therefore, it is important to establish the empirical validity of the purchasing power
parity theory. Another important implication of non-stationary in real exchange rate is
that unbounded gains from arbitrage in traded goods are possible. In fact, Parikh and
Williams (1998) have mentioned that a non-stationary real exchange rate can cause
severe macroeconomic disequilibrium that would lead to real exchange rate devalua-
tion in order to correct for external imbalance. Table 1 reports summary statistics of
data, and we find that all data series are non-normal. As pointed by Koenker and Xiao
(2004), the quantile-based unit root test has higher power than conventional unit root
tests in case of departure from Gaussian residuals, and these further confirm the use
of quantile unit root test in this paper.
3 The methods: quantile autoregressive unit root tests
Let ret denote the log of real exchanger rate in our case and εt a serially uncorrelated
error term. An AR(q) process for ret with drift a is given by:

q
ret = a + γi ret−1 + εt , t = q + 1, q + 2, . . . , n. (3)
i=1
q
The sum of the autoregressive coefficients is α = i=1 γi —a measure of persistence
that we will focus on in our study. We can rewrite Eq. (3) as:
123

q−1
ret = αret−1 + a + φi ret−i + εt (4)
i=1
Here we can run the usual unit root test. If α = 1, then the real exchange rate has a unit
root, and therefore, shocks have permanent effects on real exchange rate. If we have
α < 1, then real exchange rate is stationary. In this case, shocks have only temporary
effects on real exchange rate and this means PPP holds in this case.
To gain more detailed estimates to analyze persistence, we can focus not only
on the conditional mean, but also in the tails of the conditional distribution of ret ,
and here we can estimate Eq. (4) using quantile autoregression
methods. The τ th
conditional quantile is defined as the value Q τ (ret ret−1 , . . . , ret−q ) such that the
probability
that output conditional on its recent and past history will be less than
Q τ (ret ret−1 , . . . , ret−q ) is τ . For example, if exchange rate is very high (low) rela-
tive to recent exchange rate level, this means that a large positive (negative) shock has
occurred and that ret is located above (below) the mean conditional on past observa-
tions ret−1 , . . . , ret−q somewhere in the upper (lower) conditional quantiles.
The AR(q) process of real exchange rate at quantile τ can be written as:
q−1
Q τ ret ret−1 , . . . , ret−q = α(τ )ret−1 + a(τ ) + φi (τ )ret−i . (5)
i=1
The test has been extended by Galvao (2009) to include deterministic components
which is essential for unit root tests of drifting time series like real exchange rate
in our case. Following Galvao (2009), we can extend Eq. (5) to include stationary
covariates for unit root testing. Galvao (2009) has proved that his proposed model has
more power than standard quantile unit test model. We can express his model as:
q−1
Q τ ret ret−1 , . . . , ret−q = α(τ )ret−1 + a(τ ) + φi (τ )ret−i
i=1
−q2

+ γ I (τ )X t−I + Fu−1 (τ ) (6)
I =−q1
where Fu denotes the common distribution function of errors. Let a(τ ) = a + Fu−1 (τ )
define Z = (1, ret−1 , ret−2 , . . . , ret−q+1 , X t−q2 . . . , X t+q1 )T . Here we can
define X t−I as stationary covariates (such as difference nominal exchange rate, stock
returns, and inflation rate in our study). By estimating Eqs. (5) and (6) at different
quantiles τ ∈ (0, 1), we can get a set of estimates of the persistence measure as α(τ ).
We can test α(τ ) = 1 at different values of τ to analyze the persistence of the exchange
rate impact of positive and negative shocks and shocks of different magnitude using
the quantile autoregression-based unit root test proposed by Koenker and Xiao (2004).
Let α(τ ) be the quantile regression estimator. To test H0 : α(τ ) = 1, we use the
t-stat for α(τ ) proposed by Koenker and Xiao (2004) which can be written as
123
f (F −1 (τ )) 1/2
tn (τ ) = √ er−1 M Z er−1 (α(τ ) − 1) , (7)
τ (1 − τ )
where f (u) and F(u) are the probability and cumulative density functions of εt , re−1
is the vector of lagged log-real exchange rate, and Mz is the projection matrix onto the
space orthogonal to Z = (1, ret−1 , ret−2 , . . . , ret−q+1 )T for Koenker and Xiao
(2004) approach or Z = (1, ret−1 , ret−2 , . . . , ret−q+1 , X t−q2 . . . , X t+q1 )T
for Galvao (2009) approach.2 We use the results derived by Koenker and Xiao (2004)
and Galvao (2009) to find the critical values of tn (τ ) for different quantile levels. We
can estimate f (F −1 (τ )) following the rule given in Koenker and Xiao (2004) and
Galvao (2009). Besides allowing for asymmetric effects of shocks on real exchange
rate, an important advantage of QAR-based unit root tests over standard unit root tests
is that they have more power (Koenker and Xiao 2004; Galvao 2009).
In contrast, a more complete inference of the unit root process based on the quantile
approach involves exploring the unit root property across a range of quantiles. To
this end, both Koenker and Xiao (2004) and Galvao (2009) suggest the Quantile
Kolmogorov–Smirnov (QKS) test, which is given as
QKS = sup |tn (τ )| (8)

τ ∈
where tn (τ ) is given by Eq. (7) and = (0.1, 0.2, . . . 0.9) in our later applications.
In other words, we first calculate tn (τ ) for all τs in and then construct the QKS test
statistic by selecting the maximum value across . While the limiting distributions of
both tn (τ ) and QKS tests are nonstandard, both Koenker and Xiao (2004) and Galvao
(2009) also suggest the use of a resampling (number of bootstrap = 10000 in our case)
procedure to approximate their small-sample distributions.3
4 Empirical results
We begin our empirics by first applying three conventional unit root tests—ADF, PP,
and KPSS tests. The results in Table 2 clearly indicate that both the ADF and the
PP tests fail to reject the null of non-stationary real exchange rate for all 7 transition
countries, with the exception of Romania. KPSS test get similar results. These results
are consistent with those of Baharumshah and Borsic (2008), Liu et al. (2012), Chang
and Tzeng (2013), and Bahmani-Oskoee et al. (2015), indicating that PPP does not
hold in most transition countries.
As mentioned before, due to deficiencies associated with conventional unit root
tests, we now consider the quantile unit root of Koenker and Xiao (2004) first. Here
we test the null of α(τ ) = 1 for τ = 0.1, 0.2, 0.3, 04, . . . , 0.9 by using t statistic
(tn (τ )) based on Eq. (7). Table 3 show the point estimates, the t statistics, the critical
2 Details about the selection of bandwidth, of kernel, and of truncation parameters, we follow the suggestion
of Koenker and Xiao (2004) and Galvao (2009). Interested reader can refer to Koenker and Xiao (2004)
and Galvao (2009).
3 For more details, see Koenker and Xiao (2004) and Galvao (2009).
123
Table 2 Univariate unit root tests
Level 1st Difference
ADF PP KPSS ADF PP KPSS
Bulgarian −1.253(0) −1.261[1] 1.587(11)∗∗∗ −13.587(0)∗∗∗ −13.587[0]∗∗∗ 0.278(0)

Czech −1.523(0) −1.514[3] 1.506(11)∗∗∗ −15.150(0)∗∗∗ −15.135[3]∗∗∗ 0.271(2)
Hungarian −1.529(0) −1.516[3] 1.346(11)∗∗∗ −14.506(0)∗∗∗ −14.509[2]∗∗∗ 0.203(2)
Lithuanian −1.382(0) −1.384[3] 1.581(11)∗∗∗ −14.446(0)∗∗∗ −14.446[3]∗∗∗ 0.286(3)
Poland −1.868(0) −1.930[4] 1.312(11)∗∗∗ −14.379(0)∗∗∗ −14.380[3]∗∗∗ 0.123(3)
Romanian −4.516(0)∗∗∗ −4.084[7]∗∗∗ 1.204(11)∗∗∗ −13.424(0)∗∗∗ −14.209[8]∗∗∗ 0.585(8)∗∗
Russian −1.247(1) −1.234[6] 1.478(11)∗∗∗ −11.341(0)∗∗∗ −11.379[4]∗∗∗ 0.187(6)
∗∗∗ , ∗∗ , and ∗ indicate significance at the 0.01, 0.05, and 0.1 level, respectively. Bold values represent the
significant relation to the critical values. The number in parentheses indicates the lag order selected based on
the recursive t statistic, as suggested by Perron (1989). The number in the brackets indicates the truncation
for the Bartlett Kernel, as suggested by the Newey–West test (1987)
values, half-life of a shock, and QKS for each country. We find that H0 : α(τ ) = 1 can
be rejected at the 10 % significance level over the whole conditional real exchanger
rate distribution based on Quantile Kolmogorov–Smirnov test (QKS) for 3 out of 7
countries (i.e., Bulgaria, Lithuania, and Romania). The results confirm that all types of
shocks to real exchange rate lead to temporary effects in these 3 transition countries.
This means that PPP holds in these 3 transition countries (i.e., Bulgaria, Lithuania,
and Romania).
Table 3 also shows the persistent estimates of α(τ ) for τ = 0.1, 0.2, 0.3, . . . . . . , 0.9
in each transition country. The persistence parameter estimates are close to one for
all the quantiles considered in Czech Republic, Hungary, Poland, and Russia. The
persistent point estimate is slightly above one at the upper tail quantile for Bulgaria,
Czech Republic, Hungary, and Poland and lower tail quantile for Lithuania. Overall,
the parameter estimates are relatively homogeneous over the conditional exchange
rate distribution.4 Because PPP holds in Bulgaria, Lithuania, and Romania, Table 3
also calculate half-life of a shock for those 3 countries. We find that the estimated
half-life based on quantile autoregressive model is about 12–25 months (1–2 year).
Can we improve the results by shifting to Galvao (2009) test?
Galvao (2009) points out that his proposed quantile unit root test with stationary
covariates has more power than that of Koenker and Xiao (2004). We follow Elliott
and Pesavento (2006), Su et al. (2012) and Liu and Chang (2013) to choose the
stationary covariates according to economic theory. In our study, we use the first
differences in nominal exchange rates, inflation, and stock returns. Results for these
three stationary covariates are reported in Tables 4, 5, and 6, respectively. Based on
results from Table 4, we can see that PPP now holds in all seven transition countries
when difference nominal exchange rates serve as stationary covariates, based on QKS
statistics. Table 5 reports our empirical results when we use stock returns to serve as
our stationary covariates, and we find that PPP holds in four of these seven transition
4 Significant results in certain quantiles indicate asymmetric adjustment of real exchange rate process.
123
Table 3 Empirical results of quantile estimation and unit root tests for each quantile (without taking into stationary covariates)—Koenker and Xiao (2004)
123
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Bulgaria
α1 (τ ) 0.945∗∗ 0.972 0.980 0.987 0.994 0.996 1.004 1.016 1.045
Half-lives 12.345
QKS for quantiles of 10–90 %: 3.478∗∗∗ (0.009)
Czech Republic
α1 (τ ) 0.957 0.964∗∗ 0.982 0.976 0.992 0.995 1.009 1.016 1.032
Half-lives 19.013
QKS for quantiles of 10–90 %: 2.636
Hungary
α1 (τ ) 0.981 0.982 0.990 0.985 0.993 0.996 1.004 1.011 1.001
Half-lives
Lithuania
α1 (τ ) 1.009 1.026 1.008 1.007 0.998 0.991 0.978 0.973∗∗ 0.955∗∗

Half-lives 25.612 15.192
QKS for quantiles of 10–90 %: 2.973∗∗ (0.012)
Poland
α1 (τ ) 0.991 0.988 0.995 0.978 0.979 0.984 1.007 0.987 0.989
Half-lives
Table 3 continued
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Romania
α1 (τ ) 0.944∗∗ 0.964 0.978 0.981 0.985 0.995 0.999 1.008 1.020
Half-lives 12.161
Russia
α1 (τ ) 0.989 0.988 0.993 0.992 0.991 0.987 0.989 0.988 0.984
Half-lives
∗∗ and ∗∗∗ denotes significance at 5 and 1 % levels, respectively. Bold values represent the significant relation to the critical values. Numbers in parentheses denote bootstrap
p values with the bootstrap replications set to be 10,000. For α1(τ ), the unit root null is examined with the tn(τ ) statistic. The lag length q is selected based on robust Schwarz
information criterion as suggested by Galvao (2009) with a maximum lag set to be 12. The number in parentheses is p value.
123
Table 4 Empirical results of quantile estimation and unit root tests for each quantile (taking into account stationary covariates—first difference of nominal exchange
rate)—Galvao (2009)
123
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Bulgaria
α1 (τ ) 0.964∗∗∗ 0.974∗∗∗ 0.984∗∗∗ 0.987∗∗∗ 0.997 1.001 1.004 1.007 1.022
δ̂ 2 0.004 0.098 0.027 0.005 0.007 0.002 0.0003 0.0002 0.0012
Half-lives 18.905 26.311 42.974 52.971
QKS for quantiles of 10–90 %: 5.834∗∗∗ (0.000) [8, 1, 1]
Czech Republic
α1 (τ ) 0.958∗∗∗ 0.981∗∗ 0.982∗∗∗ 0.987∗∗∗ 0.992∗∗∗ 1.003 1.005 1.011 1.015
δ̂ 2 0.002 0.050 0.056 0.0066 0.0385 0.0127 0.0654 0.1012 0.003
Half-lives 16.154 36.134 38.160 52.971 86.296
Hungary
α1 (τ ) 0.977∗∗∗ 0.982∗∗∗ 0.986∗∗∗ 0.989∗∗∗ 0.993∗∗ 1.000 1.003 1.004 1.011
δ̂ 2 0.0034 0.0003 0.003 0.001 0.0245 0.0672 0.0032 0.0357 0.158
Half-lives 29.788 38.160 49.163 62.666 98.674

Lithuania
α1 (τ ) 0.996 0.999 0.998 1.0004 1.0009 1.004 1.008 1.0.10 1.010
δ̂ 2 0.029 0.101 0.0169 0.0417 0.0323 0.007 0.0039 0.0686 0.0022
Half-lives
QKS for quantiles of 10–90 %: 4.455∗∗ (0.000) [1, 1, 1]
Table 4 continued
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Poland
α1 (τ ) 0.987 0.984∗∗∗ 0.985∗∗∗ 0.989∗∗∗ 0.991∗∗∗ 0.995 0.997 1.006 1.011
δ̂ 2 0.0018 0.0040 0.0173 0.0612 0.0135 0.0533 0.0458 0.0702 0.0684
Half-lives 42.974 45.862 62.666 76.669
Romania
α1 (τ ) 1.007 1.012 1.0185 1.019 1.0158 1.0154 1.0149 1.0154 1.0173
δ̂ 2 0.415 0.0949 0.0716 0.0047 0.0065 0.0646 0.0796 0.0191 0.3152
Half-lives
Russia
α1 (τ ) 0.987∗∗∗ 0.9884∗∗∗ 0.9885∗∗∗ 0.9894∗∗∗ 0.9912∗∗∗ 0.9946∗∗∗ 0.9957 0.9981 1.0018
δ̂ 2 0.0618 0.0031 0.0732 0.0267 0.0364 0.00005 0.0231 0.0200 0.1293

Half-lives 52.971 59.406 59.926 65.044 78.419 128.104
p values with the bootstrap replications set to be 10,000. For α1(τ ), the unit root null is examined with the tn(τ ) statistic. The lag lengths p and q in the bracket are selected
based on robust Schwarz information criterion as suggested by Galvao (2009) with a maximum lag set to be 12. The number in parentheses is p value
123
Table 5 Empirical results of quantile estimation and unit root tests for each quantile (taking into account stationary covariates—Stock Return)—Galvao (2009)
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
123
Bulgaria
α1 (τ ) 0.9506∗∗∗ 0.9619∗∗∗ 0.9626∗∗∗ 0.9584∗∗∗ 0.9551∗∗∗ 0.9735∗∗ 0.9737∗∗ 0.9952 1.0416
δ̂ 2 0.0416 0.0374 0.1161 0.0329 0.0980 0.1243 0.1269 0.3535 0.2921
Half-lives 13.681 17.844 18.185 16.313 15.088 25.808 26.007
Czech Republic
α1 (τ ) 0.9465∗∗∗ 0.9763∗∗ 0.9787∗∗ 0.9815 0.9913 1.0048 1.0139 1.0233 1.0229
δ̂ 2 0.0689 0.0006 0.0350 0.0069 0.0227 0.0469 0.0253 0.1724 0.1966
Half-lives 12.606 17.844 32.194
Hungary
α1 (τ ) 0.9679 0.9711∗∗ 0.9811 0.9941 0.9988 1.007 1.004 1.0159 1.0163
δ̂ 2 0.3464 0.0417 0.0009 0.0055 0.0009 0.0044 0.0241 0.0924 0.0620
Half-lives 23.553
QKS for quantiles of 10–90 %: 2.1851 [1, 1, 1]
Lithuania
α1 (τ ) 0.9744∗ 1.0139 0.9989 0.9981 0.9944 0.9876 0.9782∗∗ 0.9718∗∗ 0.9607∗∗
δ̂ 2 0.0173 0.0465 0.0243 0.0095 0.0243 0.0103 0.1275 0.0884 0.2551
Half-lives 26.727 31.447 32.194 17.288
Poland
α1 (τ ) 0.9746 0.9713 0.9827 0.9719 0.9996 1.0033 1.0227 1.0302 1.0030
δ̂ 2 0.0934 0.1269 0.0005 0.0525 0.0176 0.0011 0.0265 0.1068 0.0528
Half-lives
Table 5 continued
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Romania
α1 (τ ) 0.9591 0.9349∗ 0.9777 0.9820 1.0035 1.0021 0.9953 0.9854 1.0116
δ̂ 2 0.0281 0.1089 0.1348 0.1201 0.0141 0.0455 0.2059 0.1455 0.0000
Half-lives 10.287
QKS for quantiles of 10–90 %: 2.8618∗ (0.075) [1, 1, 3]
Russia
α1 (τ ) 0.9818∗∗∗ 0.9856∗∗ 0.9888∗ 0.9912∗ 0.9883∗∗∗ 0.9898∗∗ 0.9923 0.9908 0.9855
δ̂ 2 0.2338 0.1430 0.0693 0.0222 0.0914 0.2238
Half-lives 37.737 47.787 61.540 78.419 58.896 67.608
123
Table 6 Empirical results of quantile estimation and unit root tests for each quantile (taking into account stationary covariates—Inflation)—Galvao (2009)
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
123
Bulgaria
α1 (τ ) 0.954∗∗∗ 0.972∗∗∗ 0.980∗∗ 0.991 1.001 1.004 1.011 1.032 1.038
δ̂ 2 0.1198 0.0579 0.1071 0.0053 0.0393 0.0091 0.2027 0.0117 0.0428
Half-lives 14.719 24.407 34.309
Czech Republic
α1 (τ ) 0.9592∗∗ 0.9565∗∗∗ 0.9801∗∗ 0.9852 0.9873 0.9951 1.006 1.0127 1.0189
δ̂ 2 0.009 0.0587 0.0444 0.0067 0.0144 0.0146 0.0398 0.2173 0.0087
Half-lives 16.639 15.585 34.483
Hungary
α1 (τ ) 0.9723 0.9884 0.9916 0.9941 0.9979 0.9969 1.0131 1.0035 1.0028
δ̂ 2 0.4529 0.1367 0.0160 0.0028 0.0830 0.0013 0.0032 0.1553 0.0097
Half-lives
Lithuania
α1 (τ ) 1.0069 1.005 1.0146 1.0062 1.0003 0.9901 0.9802∗∗ 0.9644∗∗∗ 0.9472∗∗∗
δ̂ 2 0.0141 0.0001 0.0357 0.0231 0.0079 0.0000 0.1158 0.0395 0.2385
Half-lives 34.659 19.122 12.778
Poland
α1 (τ ) 0.9581 0.9945 0.9846 0.9751 0.9761 0.9914 1.0022 1.0155 1.0067
δ̂ 2 0.3591 0.0487 0.0282 0.2471 0.1639 0.0784 0.1919 0.0332 0.0148
Half-lives
Table 6 continued
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Romania
α1 (τ ) 0.9476∗∗∗ 0.9653∗∗ 0.9789∗∗ 0.9829∗ 0.9895 0.9960 1.005 1.009 1.0069
δ̂ 2 0.4235 0.9574 0.3186 0.1973 0.1908 0.0843 0.2506 0.4127 0.1368
Half-lives 12.878 19.627 32.503 40.187
Russia
α1 (τ ) 0.9746∗∗ 0.9793∗∗ 0.9868∗∗ 0.9916∗ 0.9876∗∗∗ 0.9818∗∗∗ 0.9818∗∗ 0.9802∗ 0.9653∗∗
δ̂ 2 0.1245 0.2737 0.4356 0.0206 0.0020 0.0088 0.0535 0.0088 0.3335
Half-lives 12.878 33.138 52.163 82.170 55.552 37.737 37.737 34.669 19.626
QKS for quantiles of 10–90 %: 2.9689∗∗ (0.047)[1, 12, 4]
123
countries (i.e., Bulgaria, Czech Republic, Romania, and Russia). On the other hand,
Table 6 reports our empirical results when we use inflation rates to serve as our
stationary covariates, and we find that PPP holds in five of these seven transition
countries (i.e., Bulgaria, Czech Republic, Lithuania, Romania, and Russia). Based on
these findings, we can conclude that quantile unit root test with stationary covariates
proposed by Galvao (2009) provides more evidence in support of the PPP.
Perron (1989) has pointed out that failure to account for structural breaks in testing
for unit root could result in misleading findings. We, therefore, extend quantile-based
unit root test model by incorporating both sharp shifts and smooth breaks proposed by
Bahmani-Oskooee et al. (2014) to enhance estimation accuracy. We model the mean
reversion properties in the real exchange rates series with both sharp shifts and smooth
breaks for estimation of a level equation following Bahmani-Oskooee et al. (2014) and
specify its function as:

m+1
n
n
2π kt 2π kt
ret = α + θl DUl,t + γ1,k sin + γ2,k cos + εt (9)
T T
l=1 k=1 k=1
In Eq. (9), ret follows the same definition as before, and t, T, and m are time trend,
sample size, and the optimum number of breaks, respectively. The other regressors
are defined as:

1 if TBk−1 < t < TBk
DUk,t = (10)
0 otherwise
Note that DU is entered into the specification in order to capture sharp shifts.5 Fol-
lowing Gallant (1981), in order to obtain a global approximation from the smooth
transition,
Bahmani-Oskooee et al. (2014) use the Fourier approximation and enter
both nk=1 γ1,k sin( 2πTkt ) and nk=1 γ2,k cos( 2πTkt ) into the model. Here n and k
present the number of frequencies that are contained in the approximation where
n ≤ T2 .
Estimation of Eq. (9) involves selecting values for m, n, and k. As noted by Becker
et al. (2004), it is reasonable that we restrict n = 1 because if γ1,k = γ2,k = 0 can be
rejected for one frequency, then the null hypothesis of time invariance is also rejected.
Also Enders and Lee (2012) noted that imposing the restriction n = 1 is useful in order
to save the degrees of freedom and avoid over-fitting problem. Hence, we re-specify
Eq. (9) as follows:

m+1
2π kt 2π kt
ret = α + θl DUl,t + γ1 sin + γ2 cos + εt (11)
T T
l=1
The approach is to remove the impact of possible structural breaks (sharp and smooth)
from the real exchange rate once we approximate the break dates. To this end, we
5 Equation (9) is not only an extension of Enders and Holt (2012) but also a combination of Carrión-i-
Silvestre et al. (2006) and Becker et al. (2006) tests.
123
Table 7 Empirical results of quantile estimation and unit root tests for each quantile (taking into account
both sharp and smooth breaks)
τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9
Bulgaria
α1 (τ ) 0.790 0.831∗∗ 0.828∗∗ 0.869∗∗ 0.877∗∗ 0.863∗∗ 0.824∗∗ 0.805 0.780
Half-lives 3.744 3.672 4.936 5.281 4.704 3.580
Czech Republic
α1 (τ ) 0.743 0.783∗∗ 0.837∗∗ 0.788∗∗ 0.798∗∗ 0.805∗∗ 0.801∗∗ 0.736∗∗ 0.671
Half-lives 2.833 3.895 2.909 3.071 3.195 3.124 2.261
Hungary
α1 (τ ) 0.790 0.807∗∗ 0.829∗∗ 0.768∗∗ 0.723∗∗ 0.718∗∗ 0.776∗∗ 0.791 0.678
Half-lives 3.232 3.696 2.626 2.137 2.092 2.733
QKS for quantiles of 10–90 %: 5.112∗∗∗ 0.009
Lithuania
α1 (τ ) 0.649∗∗ 0.673∗∗ 0.712∗∗ 0.793∗∗ 0.774∗∗ 0.751∗∗ 0.770∗∗ 0.719∗∗ 0.677
Half-lives 1.603 1.750 2.041 2.989 2.705 2.421 2.652 2.101
Poland
α1 (τ ) 0.712 0.723∗∗ 0.781∗∗ 0.797∗∗ 0.759∗∗ 0.765∗∗ 0.691∗∗ 0.718 0.674
Half-lives 2.137 2.804 3.054 2.514 2.588 1,875
Romania
α1 (τ ) 0.487∗∗ 0.626∗∗ 0.784∗∗ 0.808∗∗ 0.845∗∗ 0.878∗∗ 0.824∗∗ 0.788∗∗ 0.787
Half-lives 0.963 1.479 2.848 3.251 4.265 5.323 3.581 2.909
Russia
α1 (τ ) 0.928 0.947∗∗ 0.955 0.933∗∗ 0.977 0.979 1.002 0.981 0.936
Half-lives 12.728 9.955
∗∗ denotes significance at 5 % level. Bold values represent the significant relation to the critical values.
Numbers in parentheses denote bootstrap p values with the bootstrap replications set to be 10,000. The lag
length p and q are selected based on robust Schwarz information criterion as suggested by Galvao (2009)
with a maximum lag set to be 12. For α1(τ ), the unit root null is examined with the tn (τ ) statistic. The
number in parentheses is p value
follow the procedure adopted by Tsong and Lee (2011) and reconstruct a new time
series of the real exchange rate by taking into account both sharp shifts and smooth
breaks as:

m+1
2π kt 2π kt
yt = ret − α̂ − θ̂l DUl,t − γ̂1 sin − γ̂2 cos + εt (12)
T T
l=1
123
Table 8 Estimation results for the mean-reverting function in Eq. (11)
Countries Optimum F stat 90 % 95 % 97.50 % 99 %

frequency
Panel A: The results for optimum frequency and the F statistic and its critical values
Bulgarian 2 39.234 2.268 2,939 3.651 4.501
Czech Rep 1 473.321 2.285 3.056 3.712 4.587
Hungary 2 38.534 2.340 3.011 3.782 4.709
Lithuania 1 121.506 2.399 3.099 3.755 4.592
Poland 1 124.572 2.353 3.132 3.770 4.743
Romania 1 73.521 2.457 3.161 3.874 4.810
Russian 3 51.917 2.381 3.093 3.936 4.774
Countries Break dates
Panel B: The results for sharp drift dates in Eq. (11)

Bulgarian 2001.09 2005.01 2010.11 2011.11
Czech Rep 2001.02 2002.03 2009.04
Hungary 2001.02 2002.03 2003.12 2006.11 2007.09 2010.08
Lithuania 2001.06 2002.04 2004.02 2006.08 2010.10 2012.12
Poland 2001.11 2003.06 2007.09
Romania 1999.08 2000.04 2005.09 2006.02 2009.10 2011.12
Russian 1999.08 2002.03 2008.11 2009.09 2012.03
where yt is real exchange rate adjusted by the effects of possible structural breaks (for
both sharp shifts and smooth breaks).6 We then apply quantile unit root test proposed
by Koenker and Xiao (2004) to test for unit root in our adjusted new series yt . We
report these empirical results in Table 7. Table 7 also shows the point estimates, t
statistics, critical values, half-life of a shock, and QKS for each country. We find that
H0 : α(τ ) = 1 can be rejected at the 5 % significance level over the whole conditional
real exchanger rate distribution based on Quantile Kolmogorov–Smirnov test (QKS)
for all seven countries (i.e., Bulgaria, Czech Republic, Lithuania, Hungary, Poland,
Romania, and Russia). These results confirm that all types of shocks to real exchange
rates lead to temporary effects which implies that PPP holds in these seven transition
countries after we take into account both sharp shifts and smooth breaks. From Table 7,
we also gather that the estimated half-life based on quantile autoregressive model is
about 1–12 months (1 month to 1 year). Our empirical results highlight the importance
of modeling both sharp shifts and smooth breaks into quantile-based unit root test
model. Table 8 reports the estimation results for the mean-reverting function in Eq. (11)
which further confirm our findings.
Figure 1 displays the time paths of the real exchange rates where a positive change
in the exchange rate indicates real depreciation. We can clearly observe structural
6 For details of how to estimate (11) and (12) refer to Bahmani-Oskooee et al. (2014), Bahmani-Oskoee
et al. (2015).
123
.12 55 90
.11 50
80
.10 45
70
.09 40
.08 35 60
.07 30
50
.06 25
40
.05 20
.04 15 30
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
BULGARIA BULGARIAH CZECH CZECHH HUNGARY HUNGARYH
10 7.0 10
6.5 9
9
8
6.0
8 7
5.5
6
7 5.0
5
4.5
6 4
4.0
3
5
3.5 2
4 3.0 1
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
LITHUANIA LITHUANIAH POLAND POLANDH ROMANIAN ROMANIANH
55
50
45
40
35
30
25
20
15
10
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
RUSSIA RUSSIAH
Fig. 1 Time series plot of real exchange rates and fitted nonlinear flexible intercept with sharp shifts and
smooth breaks for each country
shifts in the trend of the data. Accordingly, it appears sensible to allow for both sharp
shifts and smooth breaks in testing for a unit root (and/or stationary). The estimated
time paths of the time-varying intercepts are also shown in all figures. Because the
actual nature of break(s) is generally unknown, there is no specific guide as to where
and how many breaks to use in testing for a unit root or stationarity. Using an incorrect
specification for the form and number of breaks can be as problematic as ignoring
the breaks altogether. A further examination of the figures indicates that both dummy
variables (sharp shifts) and Fourier approximations (smooth beaks) seem reasonable
and support the notion of long swings in real exchange rates. Accordingly, it appears
sensible to allow for both sharp drifts and smooth breaks in our approach.
One major policy implication of our study is that the validity of using PPP to
determine the equilibrium exchange is unambiguous for all of these seven transition
countries. In these countries, the PPP could be used to determine whether a currency is
over- or undervalued. Nevertheless, reaping unbounded gains from arbitrage in traded
goods is not possible. Furthermore, the findings in support of the PPP imply that
deviations in the short run from the PPP are not prolonged for most of the transition
countries and there are some forces which are capable of bringing the exchange rate
back to its PPP values in the long run.
Our results have important policy implication on cross-border agreement for inter-
national trade and investment with these countries. Given the goods and services
markets appear quite integrated, future liberalization will likely affect financial mar-
kets. If we envision this process of integration continuing, in particular in the transition
123
countries, and to the extent that this process requires even more political engagement,
we believe the prospects for cooperation along a variety of dimensions are good. It is
noteworthy that the results here are in contrast with those of Beko and Borsic (2007),
Baharumshah and Borsic (2008), Acaravci and Ozturk (2010) and Liu et al. (2012)
who provided weak (or no) support for PPP in various groups of transition countries
using traditional unit root tests.
5 Conclusions
This study applies quantile unit root test proposed by Koenker and Xiao (2004) and
Galvao (2009) to revisit the purchasing power parity (PPP) in seven transition coun-
tries: Bulgaria, Czech Republic, Hungary, Lithuania, Poland, Romania, and Russia
using monthly data over January 1998 to March 2015. While traditional unit root tests
fail to support PPP, quantile unit root tests provide strong support for the PPP even after
accounting for sharp shifts and smooth breaks in all seven countries. The estimated
half-life based on quantile autoregressive model is about 12–25 months (1–2 year). The
transition countries started their liberalization programs in the late 1980s and early
1990s. In some of these countries, this period was characterized by dramatic improve-
ments in budget deficits, debts, and inflation. As these countries became increasingly
open to trade (and inflation and growth rates converged to those of developed coun-
tries), we would expect to find more favorable evidence of the parity condition using
data for recent years (Bahmani-Oskoee et al. 2015). In fact, many of these countries
adopted trade policies that mimic those of the European Union (EU), with a view to
alignment in readiness for membership. As the reform process (price liberalization and
trade opening) intensified, we could expect a reduction in persistent shocks to inter-
national parity (Bahmani-Oskoee et al. 2015). Our empirical results seem to support
these claims.
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Revisiting purchasing power parity in

Eastern European countries: quantile unit

Mohsen Bahmani-Oskooee, Tsangyao

Revisiting purchasing power parity in Eastern

Mohsen Bahmani-Oskooee1 · Tsangyao Chang2 ·

Received: 28 June 2015 / Accepted: 6 April 2016

JEL Classification C22 · F31

Purchasing power parity (hereafter, PPP) remains an interesting research topic in

ret = net + pt∗ − Pt (2)

Table 1 Summary statistics of real exchange rate

Bulgaria Czech Hungary Lithuania Poland Romanian Russia

Mean −2.695402 3.407058 3.927358 1.919865 1.576201 1.666739 3.315126

3 The methods: quantile autoregressive unit root tests

QKS = sup |tn (τ )| (8)

Table 2 Univariate unit root tests

Level 1st Difference

ADF PP KPSS ADF PP KPSS

Bulgarian −1.253(0) −1.261[1] 1.587(11)∗∗∗ −13.587(0)∗∗∗ −13.587[0]∗∗∗ 0.278(0)

α1 (τ ) 1.009 1.026 1.008 1.007 0.998 0.991 0.978 0.973∗∗ 0.955∗∗

τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Half-lives 29.788 38.160 49.163 62.666 98.674

τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

δ̂ 2 0.0618 0.0031 0.0732 0.0267 0.0364 0.00005 0.0231 0.0200 0.1293

τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

QKS for quantiles of 10–90 %: 1.6817 [1, 1, 1]

τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

QKS for quantiles of 10–90 %: 1.4606 [1, 1, 1]

τ 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9

Table 8 Estimation results for the mean-reverting function in Eq. (11)

Countries Optimum F stat 90 % 95 % 97.50 % 99 %

Panel B: The results for sharp drift dates in Eq. (11)

BULGARIA BULGARIAH CZECH CZECHH HUNGARY HUNGARYH

LITHUANIA LITHUANIAH POLAND POLANDH ROMANIAN ROMANIANH

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