Does trade openness explain the deviation of purchasing power parity and exchange rate movement?

Abstract

Abstract Real exchange rate movements are important in determining a country’s competitiveness and trade flows. The real exchange rate also plays an important role in postulating a relationship between exchange rates and prices as explained in the theory of purchasing power parity (PPP). In this study, we examine the validity of PPP theory in four groups of economies (developed, developing, high, and low trade openness economies) from 1980 to 2016. Our main objective is to examine if trade openness matters in determining the validity of PPP. The study applied the panel unit-root tests to test for the PPP theory. Besides, a static panel threshold regression is applied to investigate the main determinants of real exchange rate movements besides testing the relative PPP theory. The panel unit-root tests revealed the validity of relative PPP theory in all cases. However, the threshold regression reported that the PPP condition may not hold in all regimes when a nonlinearity relationship exists. Foreign and domestic prices are influential in determining the PPP relationship.