Investigating Purchasing Power Parity in Central and Eastern European Countries : A Panel Data Approach

The goal of this paper is to investigate the validity of PPP for a heterogeneous group of 12 transition countries with respect to dollar and euro. The analysis relies on monthly data frequency covering the period of 1994-2008. The first generation of panel unit root tests is based on the cross-sectional independency hypothesis. This paper applies five first generation unit root tests. The cross-sectional independency hypothesis is rather restrictive and somewhat unrealistic in the majority of macroeconomic applications of unit root tests. Thus, the second generation of panel unit root tests is characterized by the rejection of the cross-sectional independence hypothesis. Within this second generation of tests, two main approaches are distinguished. The first one relies on the factor structure approach. The second approach consists of imposing few or none restrictions on the residuals covariance matrix and has been adopted the use of nonlinear instrumental variables methods or the use of bootstrap approaches to solve the nuisance parameter problem due to cross-sectional dependency. We employ several second generation panel unit root tests in this paper to scrutinize the validity of PPP theory