This paper re-examines the Purchasing Power Parity (PPP) hypothesis in which the endogenously determined break points are incorporated in thirteen major Middle East and Northern Africa (MENA) countries by using official and black market exchange rates data over 1970-1998. We utilize Lagrange Multiplier (LM) unit root test that endogenously determines structural breaks in level and trend. We find evidence of PPP for all countries using official and/or black market real exchange rates at the 10% level or better.Purchasing Power Parity (PPP), Real exchange rate, Black market, Exchange rates, Unit-root test, Structural break

Aslan, Alper

Kalyoncu, Hüseyin

Kula, Ferit

English

Research Papers in Economics

Romanian Journal of Economic Forecasting – 4/2010  125
THE VALIDITY OF PURCHASING POWER
PARITY HYPOTHESIS IN MIDDLE EAST
AND NORTHERN AFRICA COUNTRIES
Hüseyin KALYONCU
1
Ferit KULA
2
Alper ASLAN
3
Abstract
This paper re-examines the Purchasing Power Parity (PPP) hypothesis in which the 
endogenously determined break points are incorporated in thirteen major Middle East 
and Northern Africa (MENA) countries by using official and black market exchange 
rates data over 1970-1998. We utilize Lagrange Multiplier (LM) unit root test that 
endogenously determines structural breaks in level and trend. We find evidence of 
PPP for all countries using official and/or black market real exchange rates at the 10% 
level or better.  
Keywords: Purchasing Power Parity (PPP), Real exchange rate, Black market 
Exchange rates, Unit-root test, Structural break 
JEL Classification: F31, C22, C23 
I. Introduction 
Purchasing power parity (PPP) has been one of the most enduring concepts in 
international economics. The theory, which is a generalization of the law of one price, 
supposes that all goods are identical and transportation costs and trade barriers are 
very low in both countries. The absolute version of the theory asserts that under these 
conditions, the same basket of goods and services should cost the same when 
expressed in terms of the same currency. 
                                                          
1 (Corresponding Author), Meliksah University, Faculty of Economics and Administrative 
Sciences, Department of International Trade and Business, Kayseri, Turkey, Email: 
hkalyoncu@meliksah.edu.tr.
2 Erciyes University, Faculty of Economics and Administrative Sciences, Department of 
Economics, Kayseri, Turkey, Email: kulaf@erciyes.edu.tr.
3 Meliksah University, Faculty of Economics and Administrative Sciences, Department of 
International Trade and Business, Kayseri, Turkey, Email: alperaslan@meliksah.edu.tr.
9.Institute of Economic Forecasting
Romanian Journal of Economic Forecasting – 4/2010 126
On the other hand relative PPP is said to hold when the rate of depreciation of one 
currency relative to another matches the difference in aggregate price inflation 
between the two countries concerned. If the nominal exchange rate is defined simply 
as the price of one currency in terms of another, then the real exchange rate is the 
nominal exchange rate adjusted for relative national price level differences (Sarno and 
Taylor, 2002).
The validity of the PPP has been extensively tested, especially for developed 
countries In general, PPP is valid long run equilibrium condition at least in 
industrialized economies (see the survey of Froot and Rogoff, 1995; Sarno and 
Taylor, 2002; Sarno 2003). On the other hand, empirical evidence on the validity of 
long run PPP for developing countries is rather mixed (see, for example, Telatar and 
Kazdaglı, 1998; Bahmani-Oskooee and Mirzai, 2000; Basher and Mohsin, 2004; 
Kalyoncu, 2009).
There are few studies (Bahmani-Oskooee, 1998; Narayan and Prasad, 2005) on the 
exchange rates of MENA countries as a group. Their main finding from univariate 
tests is that there is evidence for PPP in only limited number of countries. A common 
feature of the studies mentioned above is that they have all used official exchange 
rates data in testing the PPP. But, a group of studies (e.g. Age´nor and Taylor, 1993; 
Luintel, 2000) that have used the black market rates have generally supported PPP 
more than those that have used official rates in the developing country context. In 
MENA countries covered in the present study, black market exchange rates have a 
long tradition. To this end, the objective of this paper is to extend the previous 
empirical literature on PPP in MENA by examining the mean reversion of official and 
black market real exchange rates.
The outline of this study is as follows. After defining the analytical framework of PPP 
hypothesis in Section II, the methodology and sources of the data employed are 
described in section III. In section IV and V empirical results and conclusion are 
presented, respectively. 
II. Analytical Framework  
In order to test purchasing power parity we begin with the calculation of the real 
exchange rate. The real exchange rate is calculated as follows: 
P
P
NER RER
*
   (1) 
where RER is the real exchange rate, NER is the nominal exchange rate and P* and 
P are the foreign and domestic prices, respectively. In logarithmic form, the real 
exchange rate can be represented by 
) log( ) log( ) log( ) log(
* P P NER RER      (2) 
Following equation shows the model of mean reverting real exchange rate 
t t t RER RER H E D     1 ) log( ) log(  (3)  The Validity of Purchasing Power Parity Hypothesis in Middle East 
Romanian Journal of Economic Forecasting – 4/2010  127
where D  and H  are constant and error term respectively. PPP suggest that real 
exchange rate series should be stationary. If real exchange rate is stationary this 
exhibit that any percentage changes in the price level between two countries would be 
offset by an equal depreciation/appreciation of the nominal exchange rate. If there is a 
unit-root in the real exchange rate this implies that shocks to the real exchange rate 
are permanent and PPP does not exist between two countries 
III. Methodology and data 
This paper applies univariate LM unit root tests with structural breaks proposed by Lee 
and Strazicich (2003). We utilize the most general model that allows for up to two 
breaks in the level and trend of the series. According to the LM (score) principle, a unit 
root test statistic can be obtained from the following regression: 
t i t
k
i t t t S S Z Y H J I G  '   '   '   ¦
~ ~
1
1
'  (4) 
Where t S
~
 de-trended series that G \
~ ~ ~
t x t Z Yt S     , for T t ,...., 2   . G
~
 is a vector of 
coefficients estimated from the regression of  Yt ' on Zt '  and  G \
~ ~
1 1 Z Y x    , where 
1 Y  and  1 Z  first observations  t Y  and  t Z , respectively.  t Z  is a vector of exogenous 
variables defined by the data generation process of the series. Model includes two 
breaks in level and trend is described by >@
'
2 1 2 1 , , , , , 1 t t t t t DT DT D D t Z   , where  1   jt D  for 
1  t bj T t , 2 , 1   j  and zero otherwise.
The unit root null hypothesis is described by  0   I  (implying a unit root with two 
breaks), and the LM test statistics are given by: 
  W ~ t statistics for the null hypothesis  0   I . (5) 
The minimum LM unit root t-statistic determines the endogenous location of two 
breaks ) 2 , 1 , / (     j T Tbj j O . The LM unit root test can endogenously determine the two 
breaks by utilizing a grid search as follows: 
) ( ~ inf O W
O
  LMt  (6) 
In order to test the validity of PPP we construct two dataset. In first dataset we use 
black market exchange rates (BMREX) and second dataset we use official exchange 
rates (OREX). 
The black market and official exchange rates data are taken from the study of 
Reinhart and Rogoff (2004). We converted these series into real exchange rates by 
using consumer price indices.  Real exchange rates are constructed defining relative 
prices as the ratio of US consumer price index (CPI) to each country’s consumer price 
index CPI. CPI data are taken from the International Monetary Fund’s International 
Financial Statistics (IMF-IFS) database. All series are expressed in logarithms.  Due to Institute of Economic Forecasting
Romanian Journal of Economic Forecasting – 4/2010 128
the lack of consistent data on the CPI index for some countries before 1970 and 
unavailability of data beyond 1998 for black market, the data spans from 1970-1998. 
The thirteen MENA countries considered in this study are Algeria, Egypt, Iran, Iraq, 
Israel, Jordan, Lebanon, Libya, Morocco, Saudi Arabia, Syria, Tunisia and Turkey.
IV. Empirical Strategy and Results 
Following Lee at al. (2004), in the beginning, we determine the number of lagged 
augmentation terms and we start from a maximum of k=8 lagged terms. As such, the 
procedure looks for the significance of the last augmented term. We then use the 10% 
asymptotic normal value of 1.645 on the t-statistic of the last first differenced lagged 
term. After determining the optimal k at each combination of two break points, we can 
determine the breaks where the endogenous two break LM t-test statistic is at a 
minimum. We examine each possible combination of two break points over the time 
interval [0.1T, 0.9T] while eliminating the endpoints. Here, T is the sample of size.
We begin with the LM unit root t-statistic with two breaks and examine the significance 
of the dummy coefficients on the basis of the conventional t-statistics. If less than two 
breaks are significant at 10% we apply the minimum LM unit root t-statistic with one 
break proposed by Lee and Strazicich (2004).
Table 1 
Two break minimum LM unit root test 
 OREX  BMREX 
Country  LM Statistics  Breaks  LM Statistics Breaks 
Algeria -7.324 (8)***  1989
1993
-5.997 (8)**  1982
1992
Egypt  -19.804 (8)***  1984
1989
-5.732 (7)*** 1983
1987
Iran -29.443 (4)***  1986
1991
-5.115 (6)  1981
1990
Iraq -11.804 (7)***  1989 
1992
-22.872 (8)*** 1983
1991
Israel -5.598 (3)**  1981
1985
-7.475 (8)*** 1982
1994
Jordon -13.504 (8)***  1987 
1996
-11.548 (8)*** 1987
1994
Lebanon -8.725 (7)***  1982 
1985
-9.014 (2)*** 1982
1985
Libya  -13.140 (8)***  1988
1991 (N) 
-5.663 (8)*  1984
1992
Morocco -6.487 (1)***  1980 
1985
-6.601 (4)*** 1980
1984
Saudi Arabia  -7.778 (4)***  1980
1990
-7.928 (4)*** 1980
1990 The Validity of Purchasing Power Parity Hypothesis in Middle East 
Romanian Journal of Economic Forecasting – 4/2010  129
 OREX  BMREX 
Country  LM Statistics  Breaks  LM Statistics Breaks 
Syria  -11.050 (8)***  1983 (N) 
1986
-7.697 (7)*** 1983
1996 (N) 
Tunisia -4.371 (5)  1983
1986
-6.707 (7)*** 1980
1991
Turkey  -9.321 (7)***  1982 
1986
-4.891 (6)  1980 (N) 
1993
Notes: The critical values depend on the location of the breaks and are obtained from Lee and 
Strazicich (2003). *, **, and *** denote significant at the 10%, 5%, and 1% levels, respectively. 
(N) denotes that the identified break point was not significant at the 10% level. Numbers in the 
parentheses are the optimal number of lagged first-differenced terms included in the unit root 
test to correct for serial correlation.
Results of employing the two break LM unit root test for the sample period 1970–1998 
are shown in Table 1. Twelve of the thirteen OREX series reject the unit root null at 
the 5% level or better. The null hypothesis is not rejected for Tunisia. The examination 
reveals that two structural breaks in level are significant (t-values significant at 10%) 
for eleven OREX series, while only one structural break is significant in the two 
countries (Libya and Syria). The results of the unit root tests as shown in Table 1 
appear to support that the BMREX series are stationary for the sample of eleven 
countries. However, the null hypothesis is not rejected for Iran and Turkey. Table 1 
also shows that two structural breaks in level are significant eleven BMREX series. It 
is found that one structural break exist in only Syria and Turkey out of 13 countries for 
BMREX series. 
One break unit root test appears more appropriate for OREX in Libya and Syria and 
for BMREX in Syria and Turkey. We perform additional tests for these four series 
using the one break minimum LM unit root test. The results are shown in Table 2. 
Table 2 
One break minimum LM unit root test 
 OREX  BMREX 
Country  LM Statistics  Break  LM Statistics  Break 
Libya  -5.773 (8)***  1990  -  - 
Syria  -4.023 (8)  1993  -7.269 (7)***  1983 
Turkey  - -  -4.662  (6)*  1993 
Notes: The critical values depend on the location of the breaks and are obtained from Lee and 
Strazicich (2004).*, and *** denote significant at the 10% and 1% levels, respectively. Numbers 
in the parentheses are the optimal number of lagged first differenced terms included in the unit 
root test to correct for serial correlation. 
One break point is significant in all series at the 10% level. The one break results for 
OREX in Libya and for BMREX in Syria are essentially unchanged as compared to the 
two break test. But now, the unit root null is rejected for BMREX in Turkey when the 
null hypothesis is not rejected for OREX in Syria.Institute of Economic Forecasting
Romanian Journal of Economic Forecasting – 4/2010 130
Overall, we find evidence of PPP for all countries using OREX and/or BMREX at the 
10% level or better. More precisely, the unit root null is rejected for OREX in Algeria, 
Egypt, Iran, Iraq, Israel, Jordon, Lebanon, Libya, Morocco Saudi Arabia and Turkey, 
while the unit root null is rejected for BMREX in Algeria, Egypt, Iraq, Israel, Jordon, 
Lebanon, Libya, Morocco Saudi Arabia, Syria, Tunisia and Turkey. Rejection of the 
null hypothesis would imply that these series exhibit mean reverting tendencies. In 
other words, PPP holds.  
V. Conclusion 
Using official and black market real exchange rates data from thirteen MENA 
countries are examined over the period 1970–1998 to test for evidence of PPP. We 
utilize a LM unit root test that endogenously determines breaks in level and trend. We 
find that all exchange rates series reject the unit root null at the 10% significance level 
or better, except for OREX in Tunisia and Syria and for BMREX in Iran. The PPP 
holds for both official and black market real exchange rates in ten countries out of 
thirteen cases.
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The Validity of Purchasing Power Parity Hypothesis in Middle East and Northern Africa Countries

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