Purchasing Power Parity (PPP) with Structural Break and Mean Reversion in Real Exchange Rate: The Case of Bangladesh Taka and US Dollar

Abstract

This paper aims at examining the validity of purchasing power parity (PPP) both in absolute and relative terms with reference to the long run behavior of the real exchange rate of Bangladesh Taka relative to USA dollar. In doing so, the paper tests the presence of mean-reversion in the real exchange rate by using the unit root test approach i.e. Augmented Dickey-Fuller,DF-GLS, Zivot-Andrews tests. The paper verifies the long run relationship on co-integration and VAR framework. Using monthly data (01/2007-06/2013) and annual data (1986-2014), the paper finds support for both absolute and relative PPP. While the paper finds the evidence of structural change (Quandt-Andrew test and CUSUM test) only monthly data. VECM has been applied on monthly data, as there exists co-integrating equations for only monthly data (by using Johansen test ). Unit root test indicates that the real exchange rate is I (1), that is real exchange rate of Bangladesh is not stationary.