Testing For The Purchasing Power Parity Hypothesis In A Small Open Economy: A VAR-X Approach

Abstract

This paper tests the purchasing power parity (PPP) hypothesis for the rand-US dollar exchange rate by making use of the cointegrating VAR-X approach. Given that the test of PPP hypothesis conducted in this paper involves variables of a small economy, South Africa, compared to a big economy, the US, the paper contends that traditional cointegrating VAR approach that considers all variables in a given vector as endogenous is not suitable. The results of the paper show that the restriction applied in the cointegrating vector for the VAR-X model supports the weak-form PPP hypothesis. The same restrictions are rejected in the case of traditional cointegrating VAR model. The paper concludes that it is essential to distinguish between weakly exogenous and endogenous variables in tests of the PPP hypothesis that involve small and big economies.