Sunil Kumar and S. M. Lokare*

The decade of 1990s saw far reaching economic reforms in India. Ever since the switch over to market determined exchange rate that unfolded in 1993, the Indian economy has witnessed massive transformation in terms of greater external sector openness and higher degree of integration with the global economy. Against this backdrop, this paper attempts to test the validity of purchasing power parity (PPP) condition in the case of India during pre and post reform periods, using monthly data spanning over more than three decades. The results from array of unit root tests unravel that real exchange rate (RER) series remain non-stationary in the pre-reforms period and turn out to be stationary during the post reforms period, indicating thereby that PPP condition holds during the post reforms period, albeit, over the long run. These results are also corroborated by the cointegration test and vector error correction model applied to the components of RER. This lends credence to the fundamental principle that chances of holding PPP improve in an economy with greater external sector openness and integration. Holding of PPP during post-reforms period also provides support to the market determined exchange rate mechanism put in place in India during the early 1990s.

JEL Classification : C23, E50, F31

Keywords : Real Exchange Rate; Bilateral Nominal Exchange Rate, Purchasing Power Parity, Domestic Prices and US Prices

Prologue

The purchasing power parity theory is one of the oldest and most luminous topics that continues to enfold the intellectual discourse in the international economics. It constitutes a central building block in the monetary model of exchange rate determination. Salamanca School was the first to articulate the proposition of PPP in the 16th Century, while it was Gustav Cassel (1921), a Swedish economist who championed the use of PPP as a model for setting relative gold parities. However, the modern origins could be traced back to the restoration of world financial system after its collapse during World War. I.

PPP is a condition of open economy general equilibrium model. wherein, national price levels tend to be same under a common currency. It states that arbitrage forces will lead to the equalisation of goods prices internationally once the prices are measured in the same currency. The underlying principle embedded in the model is that goods market arbitrage enforces weeding out of differential in the prices of traded commodities. Efficient arbitrage in goods market across the countries emanates increasingly with external opening of economies. PPP theory provided a point of reference for the long-run exchange rate in many of the modern exchange rate theories.

The importance of PPP theorem could be gauged by its wide applications in formulating the policy decisions. It is applied, interalia, in choosing the right initial exchange rate for a newly independent country; forecasting medium and long-term Real Exchange Rate; and adjusting for price differentials in international comparisons of income. The PPP condition not only helps in understanding the nature of nominal and real shocks in the exchange rate models but also help policy makers and researchers to compute RER misalignment. A proper assessment of the deviation of the real exchange rate from its equilibrium path can go a long way in enabling policy makers to design an exchange rate policy which can achieve the long-term sustainability of the balance of payments (Joshi, 2007). A common method of determining the extent of misalignment of the exchange rate is based on the principle of PPP theory for open economies, which assumes that exchange rates adjust to offset the changes in relative prices.

There is a growing body of empirical literature on PPP and a consensus has emerged on a couple of facts. A number of studies have weighed in favour of real exchange rate tending toward purchasing power parity in the very long run. However, the speed of convergence to PPP is very slow. While few economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of purchasing power parity as an anchor for long-term real exchange rates (Rogoff K, 1996).

Few empirical studies have been undertaken to testify whether PPP holds or not in Indian case also. In this paper, we have empirically investigated PPP during pre-reforms and post reforms in the case of India’s bilateral real exchange rate (RER) with USA. We have taken monthly data from 1970 to 2008 and this was divided in two periods: period I from 1970M01 to 1993M02 and period II from 1993M03 to 2008M08. The division of time period was drawn from the structural break that took place with the introduction of liberalized exchange rate mechanism (LERM) in India in March 1993.

The objective of this paper is to test the validity of PPP theorem in an emerging Giant- India with reference to US. In this endeavor, the paper attempts to test for the existence of any stable long-term equilibrium relationship between the exchange rate and domestic/ US prices (WPI). This relationship is sought to be tested through the procedure of Johansen Co-integration technique with Vector Error Correction Model. This paper distinctly differs from the extant literature by covering a long time horizon - monthly data spawning for more than three decades (since 1970) and endeavors to test the validity of PPP in the fixed and floating rate regimes.

The paper is structured into the following sections. Section II provides a review of the empirical literature on the PPP hypothesis. Literature suggests a mixed result about holding of PPP; however, recent studies have increasingly found results in favour of PPP in the long run. Section III, delineates the process of opening up of external sector and the evolution of exchange rate regime, while Section IV discusses model specifications, data sources, and empirical results. Finally, the paper ends with the concluding remarks.

Section II
A Peep into the PPP Literature

Considering the central place that PPP occupies in the monetary models of exchange rate determination, it is not surprising that considerable amount of research has been devoted to its empirical verification.

Law of One Price: Does it hold…?

It is the Law of One Price (LOP), which forms a central pillar of PPP. LOP asserts that similar goods should be sold at similar prices across countries. In the long-run, arbitrage ensures that the LOP exists- that is identical goods denominated in a common currency must sell for the same price in two separate markets, without transportation costs and differential taxes thereby, causing intra national price convergence.

LOP states that for any good i, if traded without frictions, the following should hold:

P_it = P*_it E_t         (1)

In the equation (1), P_it and P*_it are domestic price and foreign currency price of i commodity at time t, respectively, while E_t is the nominal exchange rate at time t.

However, in practice tariffs, transportation costs and non-tariff barriers, quality standards, taxes, profit margins, monopolistic tendencies, etc., drive a wedge between prices in different countries. Theoretical and empirical literature suggests that the PPP can be violated in the short run. PPP may also not hold on account of factors, viz., (i) if there are transaction costs and trade frictions, (ii) differential baskets of goods are used to construct aggregate price indices, and (iii) government intervenes in foreign exchange markets (Duncan, Roberto, 2003).

Balassa- Samuelson (1964) provided an explanation as to why the price levels differ across countries. They argued that when all countries price levels are translated to dollars at prevailing nominal exchange rate (NER), rich countries tend to have higher price levels than the poor ones. According to them, the presence of non-traded goods, for which no international arbitrage exists, can lead to systematic movements in real exchange rates inconsistent with PPP. Productivity differentials in the traded and non-traded goods sectors remain the underlying factor for the above hypothesis. Rich countries have higher exchange rate adjusted price levels than poor countries due to differing capital labour ratios (Bhagawati, 1984).

Empirical evidence showed that PPP performs better for those countries that are geographically close to each other and where trade linkages are high. Moreover, PPP holds better for traded goods compared to non-traded goods (Officer, 1986). Reasons for failure of PPP may be attributed to heterogeneity in the baskets of goods considered for construction of price indices in various countries, imperfect competition in goods market, and increase in the volume of global capital flows during the last few decades, which led to sharp deviation from PPP. Short-term exchange rate volatility emanates from changes in portfolio preferences, short-term asset price bubbles and monetary shocks. The failure of short-term PPP could be attributed in part to stickiness in nominal prices (Rogoff, 1996).

Some believe PPP is a short-term proposition, while most believe in some variant of PPP as an anchor for RER. However, the consensus evidence indicates that- speed of convergence to PPP is extremely slow (decay at 15 per cent per year); short-term deviations are large and volatile; and real exchange rates tend toward PPP in the very long run.

Many studies rejected PPP hypothesis on the ground of unit root problem in RER. If the unit root model can characterise real exchange rate behavior, then PPP does not hold because there is no propensity to revert back to any equilibrium level (Cashin et, al, 2003). Researchers found it difficult to reject the hypothesis that major countries RER follow a random walk under floating rate regimes and hence difficult to prove convergence. Early tests include: Richard Roll, 1979; Michael Darby, 1983; Michael Adlerand Bruce Lehmann, 1983 and Edison, 1985. Later papers incorporating standard unit root tests include John Huizinga, 1987; Meese and Rogoff, 1988. The tests using co-integration methods on modern floating rate have failed too to reject random walk hypothesis (Bouncer, 1994).

The evidence is, however, inconclusive due to low power of unit root tests in small samples. In the recent literature, some studies have found evidence in favour of PPP- applying unit root tests (Frankel, 1986; Lothian and Taylor, 1996; Taylor, 2002; etc.).

Frankel was able to reject it using Dickey-Fuller tests. His estimation showed a rate of decay for RER deviations of 14 per cent per year (4.6 years) (Dickeyand Fuller, 1979). During 1990s, the long horizon data studies tend to find evidence of mean reversion in real exchange rates (Abuafand Jorion, 1990; Lothianand Taylor, Cheungand Lai, 1994). Several studies found strong rejections of the random walk model (Abuaf and Jorion, 1990; Glen, 1992; Diebold, Husted, Rush, 1991).

A study by using the panel cointegration method for market exchange rates of 17 African countries, supported the weak form of the long-run PPP hypothesis (Nagayasu, 1999). Conversely another study rejected the PPP hypothesis for Sri Lanka during the floating exchange rate regime, thereby indicating the existence of market frictions such as transaction costs prevalent in the international trade (Wikremsinghe, 2001). There is also evidence supporting the alternative hypothesis of acceptance of the PPP theorem for demeaned data provided by Mohua Paul (2002), who tested the validity of PPP for six South East Asian countries, including India, using panel unit root test for multilateral RER based on dynamic export, import and trade weights and concluded that PPP could be used to assess the levels of exchange rate. Taking in to account the data from 1973 to 1997, for a sample of 30 developing countries, Holmes (2001) confirmed the existence of PPP and proved that there was no evidence to prove that PPP is confined merely to high inflation countries as established by some studies (McNown and Wallace, 1989; Liu, 1992; Mahdavi and Zhou, 1994).

Similarly, Holmes (2002) tested non-linearity in US $/ Latin American RER and found that non-linearity existed for 7 out of 13 countries and concluded that the identification of non-linearity should offer some explanation as to why PPP does not exist in many cases. While another study using non-linear tests of stationarity and cointegration for a sample of 10 Africans countries for the Post- Bretton Woods era found that long run PPP held in 8 out of 10 countries, if an explicit distinction were made between positive and negative shocks (Holmes and Wang, 2004). A more recent study also validated the applicability of PPP hypothesis for East Caribbean Currency Union by finding that many real exchange rates are cointegrated over the period of 1980s and 1990s. There is also a study, which concludes that nominal exchange rate was consistent with PPP hypothesis and underlying behaviour of exchange rate was consistent with fundamentals (Schweigert, 2002).

While the PPP condition constitutes one of the fundamental but testable theoretical benchmarks against a set of other financial market conditions such as interest rate differential that become important in a world of dynamic cross border capital flows in the determination of real exchange rate adjustments, the issue of evaluating the fundamental equilibrium exchange rate requires probe in to the working of fundamental economic factors such as supply, demand and nominal factors, which govern the eventual outcomes of the external sector account of any country. Against this backdrop, a more recent study focused on the task of evaluating the applicability of PPP in the Indian context, while also positing a broader framework, incorporating fundamental economic factors to estimate the equilibrium real exchange rate and to identify factors that could have determined its movements during the post-reform years (Joshi, 2007). The study explored that real exchange rate in India is predominantly determined by permanent real demand shocks followed by nominal and supply shocks.

Another study in the Indian context, by Kohli (2002), using unit root and cointegration tests found mean reverting tendencies in the real exchange rate series constructed using the consumer price index as the deflator as well as for series constructed using wholesale and consumer price indices, suggesting thereby that monetary policy impulses were the main cause of disturbance in real exchange rate. Further, the evidence of non stationarity of the relative differential of tradable and non-tradable goods suggested that real shocks such as permanent changes in productivity or Government spending were important for the determination of real exchange rate movements.

Aggarwal (2000) found that prices, interest rates, and money supply in the home and foreign country are important variables in explaining the behaviour of bilateral exchange rate between India and USA. Other significant variables are found to be balance of payments items like current and capital account balances and foreign exchange reserves. The exchange rate is found to be determined by the domestic price index with a positive coEfficient and wholesale price index in the USA. with a negative coEfficient. Domestic price is explained by the domestic and foreign rates of interest and the money supply in the home country. Thus, the interest rates and money supply¹ explain the exchange rate indirectly through the domestic price. Interest rate in the home market is explained by the interest rate in the foreign country and the exchange rate between the two countries. That is, the interest rate differential between the two countries also affects the exchange rate between them.

It is also well documented in the literature that, compared to fixed exchange rate, a flexible exchange rate arrangement, under normal circumstances leads to quicker convergence towards the equilibrium because of faster self-stabilising adjustments in the nominal exchange rate in tandem with changes in fundamentals as compared with slower convergence through changes in relative price ratios, which remain sticky because of market rigidities (Joshi, 2007).

Thus, the review of literature shows that the evidence in favour of PPP is inconclusive, nevertheless the comprehensive research on the subject, especially, in the case of developing countries is rather scarce. The theory of exchange rate determination still lacks models that are both theoretically interesting and empirically defensible (Krugman, 1993). Against this backdrop, purpose of the present study is to address the question whether or not relative prices determine relative exchange rate positions in bi-lateral framework (India and US), without getting into the fundamental factors underlying the exchange rate behaviour.

Recent empirical tests of PPP have mainly focused on the long run given that there are frequent large and persistent short run deviations from PPP. Earlier empirical results on PPP have not been very encouraging , one of the reasons being the test used in many of the earlier studies is known to have low power in small samples (Hakkio (1986), DeJong, Nankervis, Savin and Whiteman (1992)). One way to increase the power of the empirical tests is to use longer span of data. For instance, Diebold, Husted and Rush (1991) and Lothial and Taylor (1996) found support to PPP. In view of the above, this study attempts to cover long span data to test the PPP hypothesis in the Indian context.

Section III
External Sector Openness in India

III. A. Opening up of India’s External Sector

The external payment crisis that India witnessed in 1991 called for wide-ranging external sector reforms. These included a marketbased exchange rate system, introduction of convertibility of the rupee for external transactions on the current account, and a compositional shift in cross-border capital inflows from debt-creating to non-debtcreating flows. FDI is encouraged through a very liberal but dual route: a progressively expanding automatic route and a case-by-case route. Indian companies were also permitted to access international markets through Global Depository Receipts/American Depository Receipts (GDRs/ADRs) under an automatic route, subject to specified guidelines. Foreign investment in the form of Indian joint ventures abroad was also permitted.

Restrictions on outflows involving Indian corporates, banks and those who earn foreign exchange (like exporters) have also been liberalised over time, subject to certain prudential guidelines. As a result of pursuing the above approach, India has attracted considerable private flows, primarily in the form of FDI, portfolio investment, ECB and NRI deposits. Indian companies have been permitted to raise resources from abroad through the issue of ADRs, GDRs, Foreign Currency Convertible Bonds (FCCBs) and ECBs. Foreign companies are also allowed to tap the domestic stock markets. FIIs have been permitted to invest in all types of securities including government securities. The Indian stock exchanges have been allowed to set up trading terminals abroad. The trading platforms of Indian exchanges are now accessed through the internet from anywhere in the world. The Reserve Bank of India (RBI) permitted two-way fungibility for ADRs/GDRs, which meant that investors (foreign institutional or domestic) who hold ADRs/GDRs can cancel them with the depository and sell the underlying shares in the market.

With the introduction of LERM and other liberalisation measures both in the case of current and capital account, Indian economy has witnessed increasing openness during the post reforms period. This fact is amply reflected by measures of external openness such as exports plus imports and capital inflows plus capital outflows as a percentage of GDP, respectively. The current account, as measured by the sum of current receipts and current payments, as a percentage of GDP improved significantly from 19 per cent in 1990-91 to about 53 per cent of GDP in 2007-08. Likewise, the sum of gross capital inflows and outflows increased from 12 per cent of GDP in 1990-91 to around 64 per cent in 2007-08.

III. B. Evolution of Exchange Rate Regime

The period after Independence in 1947 was followed by a fixed exchange rate regime where the Indian rupee was pegged to the pound sterling on account of historic links with Britain and this was in line with the Bretton Woods System prevailing at that time. With the breakdown of Bretton Woods system in the early 1970s and the consequent switch towards a system of managed exchange rates, and with the declining share of the UK in India’s trade, the Indian rupee, effective September 1975, was delinked from the pound sterling in order to overcome the weaknesses of pegging to a single currency. During the period of 1975 to 1992, the exchange rate of rupee was officially determined by the Reserve Bank within a nominal band of +/- 5 per cent of the weighted basket of currencies of India’s major trading partners. The exchange rate regime of this period can be best characterised as an adjustable nominal peg with a band, with the nominal exchange rate being the operating variable to achieve the intermediate target of a medium-term equilibrium path of the real effective exchange rate (REER).

At the beginning of the 1990s, the significant rise in oil prices and suspension of remittances from the Gulf region in the wake of the Gulf crisis led to severe problems in the balance of payments in India. A twostep downward adjustment of 18-19 per cent in the exchange rate of the Indian rupee was made on July 1 and 3, 1991 with a view to placing it at an appropriate level in line with the inflation differential with major trading partners so as to maintain the competitiveness of exports. This provided the necessary impetus for a move towards greater exchange rate flexibility. Consequently, following the recommendations of the High Level Committee on Balance of payments (Chairman: C. Rangarajan), the Liberalised Exchange Rate Management System (LERMS) involving dual exchange rate system was instituted in March 1992 in conjunction with other measures of liberalisation in the areas of trade, industry and foreign investment. Under the LERMS, 40 per cent of exchange earnings had to be surrendered at an official rate determined by the Reserve Bank, which in turn was obliged to sell foreign exchange only for import of certain essential commodities such as oil, fertiliser and life saving drugs besides the Government’s debt servicing. The balance 60 per cent of exchange earnings was to be converted at rates determined by the market. The LERMS was essentially a transitional mechanism and a downward adjustment in the official exchange rate took place in early December 1992 and ultimate convergence of the dual rates was made effective from March 1, 1993. The unification of the exchange rate of the Indian rupee was an important step towards current account convertibility, which was finally achieved in August 1994. The experience with the market determined exchange rate system in India has remained satisfactory.

India’s exchange rate policy of focusing on managing volatility with no fixed rate target while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way has stood the test of time. The foreign exchange market has been characterised by orderly conditions for most of the period, excepting a few episodes of volatility. The Reserve Bank continues to follow the same approach of watchfulness, caution and flexibility in regard to foreign exchange market. It co-ordinates its market operations carefully, particularly in regard to the foreign exchange market with appropriate monetary, regulatory and other measures as considered necessary from time to time. The conduct of exchange rate policy in India is guided by three major objectives. First, to maintain orderly conditions in the foreign exchange market by providing foreign exchange as considered necessary from time to time, and to prevent the emergence of destabilising and self-fulfilling speculative activities. Second, to help in maintaining an adequate level of foreign exchange reserves. Third, to help eliminate market constraints with a view to facilitating the development of a healthy foreign exchange market. International research on viable exchange rate strategies in emerging markets has also lent considerable support to the exchange rate policy followed by India (RBI, 2002-03).

Section IV
Model Specification, Methodology and Empirical Observations

IV. A. Model Specification

PPP model articulated first by the scholars of the Salamanca school in the sixteenth century provides that once converted in common currency, national price levels should be equal. Nominal exchange rate responds to relative changes in the price levels of different countries so that the underlying principle of one price will hold. However, this adjustment in three variables takes time and the principle of one price holds only in long run. Alternatively, real exchange rate attains equilibrium in the long-run, suggesting thereby that PPP condition does not hold in the short run. The fundamental PPP specification is delineated below.

The above specification can be estimated using simple OLS process if the variables are stationary, otherwise, regression would be spurious. In case these variables contain non-stationary process, then cointegration framework put forward by Engle and Granger (EG) in 1987 and the other by Johansen in 1988 could be used for estimation.

IV. B. Methodology

According to the co-integration theory, there may be co-integrating relationship between the variables involved if they are of the order of I(1) i.e., they are stationary at the Ist difference level and their lineal combination is I(0). A battery of unit root tests is available to find out whether the series is stationary or not. In this paper, Augmented Dickey- Fuller (ADF), Dickey-Fuller GLS, Phillips-Perron, and Kwiatkowski- Phillips-Schmidt-Shin (KPSS) tests were applied to test the unit root in time series.

The importance of cointegration tests in the modeling of nonstationary economic series becomes clear in the so-called Granger representation theorem, first formulated in Granger and Weiss (1983). Nonetheless, the necessary techniques for testing for cointegration were developed jointly by Engle and Granger (1987)¹. In this paper, we have used Johansen Maximum Likelihood Method for estimation.

The components of the specification, i.e., nominal exchange rate, Indian price level and USA price level were tested for stationarity and these variables were found to be having unit root. However, the linear combination of the components of real exchange rate was found stationary, indicating thereby that these components are cointegrated. Therefore, PPP model was specified in terms of Vector Error Correction Model (VECM). Under VECM model, when there is disequilibrium, some of the variables must respond to restore equilibrium. The error correction representation of a cointegrated system regarding PPP is set out below :

Note that the dependent variables are stationary. Hence, the equations are meaningful only if right hand side variables are stationary. If there is cointegration, the term within the parenthesis (e_t-1) is stationary. Nothing gets altered, if we specify ECM in more general form :

IV. C. Data

In this paper, we have used data from 1970M01 to 2009M03 on nominal exchange rate of Indian rupee vis-à-vis the US Dollar, wholesale price index (WPI) of India and producers price index (PPI) of the USA. PPI index mainly consists of trading commodities of USA. In order to ensure consistency, data on all these variables was taken from International Financial Statistics (IFS) of International Monetary Fund (IMF). For applying econometric tests all these variables viz., RER, exchange rate, WPI of India and PPI of USA have been used in log form. In the remainder of this chapter lexr is used for log of nominal exchange rate, lindwp for log of prices of India, and luswp for prices of USA.

IV. D. Empirical Observations

Firstly, a battery of unit root tests are applied to test for stationarity in RER during both periods I and period II. Table 1 shows that Augmented Dickey-Fuller, DF-GLS, and Phillips Perron tests accepted the null hypothesis of unit root in RER and KPSS rejected the null hypothesis of RER being stationary during period I (prereform period). While, during period II (post-reforms period), Augmented Dickey-Fuller, and Phillips Perron rejected the null hypothesis of unit root and KPSS accepted the null hypothesis of RER being stationary (Table 1). The unit root tests applied on RER showed that the PPP holds during period II (post-reforms period) and not in period I (pre-reforms period).

Furthermore, the components of RER (nominal exchange rate, prices in India and USA) were tested for unit root. These variables were found to be non-stationary series. Hence, they were tested for unit root in first difference. As shown in Annex 1-3, Augmented Dickey-Fuller, DF-GLS, and Phillips Perron tests rejected the null hypothesis of unit root at 1 per cent level, while KPSS accepted the null of stationarity at 1 per cent level during both period I and period II. All these variables are found to be integrated of order I(1) process. In the case of combination of these variables (components of RER), i.e., error term, Augmented Dickey-Fuller, DF-GLS, and Phillips Perron tests rejected the null hypothesis of unit root at 1 per cent level and KPSS accept the null of stationary at 1 per cent level only during period II (Annex 4-5) indicating that the components of RER are cointegrated only during period II and not in period I. It may be mentioned that 6 lags have been selected for VECM based on sequential modified LR test statistics.

Going forward, we have examined the order of integration of the variables using Johansen’s Trace statistics and Eigen value statistics. Both these statistics furnished in Table 2 indicate the existence of 1 cointegrating equation at 0.05 level of significance. In the light of rank of cointegration being one, we have normalised the cointegrating vector with respect to lexr and the estimated cointegrating relation.

The results of the long-run cointegration model are given in Table 3. It may be noted that normalised cointegrating parameters bear theoretically predicted sign and are found to be significant. The coEfficients of both prices in India and USA show that there is more than proportionate relationship with nominal exchange rate.

PPP theory, however, states that the coEfficients of both domestic and foreign prices should be proportionate, i.e., these coEfficients take the value 1. The significance of the difference between estimated coEfficients of LPIN and LPUS was statistically tested and t-statistics accepted the null hypothesis (Table 4). It shows that PPP theory holds in this case as coEfficients of both domestic and foreign prices are not statistically different from 1.

Further, these three variables were investigated for direction of causality using pair-wise Granger Causality. The time series pertaining to LEXR, LPIN, and LPUS are characterised with I(1) process. Since Granger causality test requires the series to be stationary, this test has been run with their first difference. Table 5 presents the results of Granger causality tests. It has been found that unidirectional causality runs from PUS (the prices in PUS) to EXR at 10 per cent level of significance. The Granger Causality running from PIN to EXR has been found to be weak and statistically insignificant. At the same time, unidirectional causality has been found running from PUS to PIN at significance level of 1 per cent.

Going forward, short-term dynamics, i.e., ECM has been found to be working in the cointegration model. The speed of adjustment parameters (coEfficients) of nominal exchange rate and US prices have been found greater than zero with negative sign and significant as manifested by t test². This confirms the Granger representation theorem that error correction model for I(1) variables necessarily implies cointegration. The significant coEfficients in Table 6 further manifest that the disequilibrium among the variables from their long-run trend is corrected through the dynamic adjustment of exchange rate and US prices but not by Indian prices in the shortrun.

When there is positive deviation in the exchange rate from its long run equilibrium level, both nominal exchange rate and US prices respond negatively (represented by a negative adjustment coEfficients). On the other hand, prices in India also respond negatively to deviations in nominal exchange rate (represented by negative adjustment coEfficient) but the coEfficient is not statistically significant. This implies that disequilibrium in the real exchange rate is being corrected by deviations in nominal exchange rate and US prices in the short run.

Section V
Concluding Remarks

Exchange rate models in the literature assume that PPP holds in the open market economies. The PPP condition not only helps in understanding the nature of nominal and real shocks in the exchange rate models but also help policy makers and researchers to compute RER misalignment. Theoretical and empirical literature suggests that the PPP can be violated in the short run. PPP may also not hold on account of factors, viz., (i) if there are transaction costs and trade frictions, (ii) differential baskets of goods are used to construct aggregate price indices, and (iii) government intervenes in foreign exchange rate markets.

The main objective of this paper is to examine the validity of PPP condition in the case of India during pre and post reform periods using monthly data from 1970 to 2009. The results of battery of tests reveal that RER is non-stationary during the pre-reform period and stationary in the post-reforms era, which underscores the fact that RER condition holds during the post reforms period. This is validated by the result of unit root tests wherein the components of RER (exchange rate, prices of India and USA) have been found cointegrated as the linear combination of RER components turned out to be stationary during the post-reforms period and not during the prereforms period.

Further, PPP condition has been estimated using VECM. The results imply that long-run relationship between exchange rate and prices of India and USA is more than proportionate but difference is statistically insignificant. However, ECM is found to be working with all the coEfficients having negative sign but statistically significant only in the case of LEXR and LPUS. The ECM coEfficients are very small, suggesting that these variables take quite a long time in correcting the deviations in the long run equilibrium exchange rate.

In sum, RER holds in the post-reforms period and not in the Prereforms period, which is validated by the cointegration tests and vector error correction model employed in this case. Thus, PPP condition holds in the long run during the post-reforms period, implying that any deviations in the equilibrium exchange rate remain transitory and revert back to the underlying trend eventually. These findings underscore and support the fundamental principle that chances of PPP improve in an economy with its increased external sector openness. Holding of PPP during post-reforms period is also consistent with liberalised exchange rate mechanism (LERM) introduced since March 1993, where exchange rate is determined by demand and supply.

NOTES :

* The authors are working in the Department of Economic Analysis and Policy, Reserve Bank of India. The views expressed in the paper are strictly personal. Errors and omissions, if any, are the sole responsibility of the authors.

¹ Engle and Granger framework is a two-step procedure wherein null hypothesis of no cointegration is tested between a set of I(1) variables applying unit root tests to the residuals. EG two-step procedure first applies Ordinary Least Squares (OLS) estimation method to the variables, and then tests the stationarity of the residual obtained from the regression equation. If the residual is stationary, then there is a cointegrating relationship between the variables. Another seminal work in the evolution of cointegration techniques is by Johansen (1988, 1991). Johansen Maximum Likelihood Method based on Vector Auto Regression (VAR) known as Vector Error Correction Mechanism (VECM) deals with more than two variables.

² In case of one cointegration relationship the significance of speed of adjustment parameters can be determined by t statistics.

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