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ussions relating to re-establishing exchange rate to equilibriums using PPP, referred exclusively to relative PPP. They further argued that shocks caused by real factors can create changes in the relative prices of commodities, especially so for low inflation economies. Moreover, there is not much evidences to support that the relative PPP will exhibits a greater robustness than the absolute PPP.

2.3 Debate of PPP and Tests for Unit root and Random walk.

In July of 1944, delegates from 44 countries met in Bretton Woods, where they drafted and signed the Articles of the International Monetary Fund (IMF). The objective of this coming together was to propose an international monetary system that will ensure internal (full employment & inflation) and external balances of the countries. The Bretton Woods agreement called for fixed exchange rates against the US dollar whilst the US dollar was tied to the price of gold. Subsequently, the “monetary approach” was commonly used during that period of time to determine exchange rates. This approach advocates that exchange rate between countries should be determined by the relative price of two monies, which is further influenced by the demand and supply factors in their respective money market. More importantly, this approach is based on the assumption that purchasing power parity does hold continuously.

From 1970s, there have been numerous studies to determine the empirical relevance of purchasing power parity theory. But due to the lack of theoretical and advanced statistical models, the results were largely disappointing. Early studies of PPP have mostly based on the simple empirical model shown below.

Where is the logarithm of the domestic currency price of good i, is the logarithm of the foreign-currency price and is the logarithm of the domestic-currency price of foreign exchange. They test the null hypothesis that = 1 and and if the null cannot be rejected, it meant the exchange rates and relative prices follows the PPP theory. On the other hand when, Purchasing power parity does not hold.

Frenkel and Johnson (1978) found some relative success for the PPP theory when testing with countries with hyper-inflation but this result was not unanticipated due to the significant monetary shocks evidenced in these hyper-inflation environments. He carried out the similar test for countries with stable situations and found that PPP theory is not valid, a result consistent with other investigation of PPP during that period. Dornbusch (1976) argued that one possible reason for the failure of PPP in the short run might have been due to exchange rate over-shooting as a result the presence of sticky prices in the short run.

One of the major drawbacks for this simple PPP model described above was that there were no test for stationary property of the time series of exchange rates and relative prices respectively. Lutkepohl and Lratzig (2004) argued that stationarity property is time-invariant; does not depend on time, in the first and second moment of a stochastic process. This implied that the time series is stationary if;

for all t T and

for all t T and all integers h such that t – h T

Without determining whether the respective time series are stationary, the variables might appear to be related even when they are not as a result of spurious regression. Hence, any estima