Purchasing Power Parity Hypothesis in Developing Economies:Some Empirical Evidence from Sri Lanka

Purchasing power parity (PPP) hypothesis has attracted a lot of attention from academics and policy-makers particularly, during the recent float. Most previous studies used data from the developed world. This study examines the validity of the PPP hypothesis using data during the recent float from Sri Lanka. In contrast to previous studies, we use unit root tests which take into account unknown means and trends in the real exchange rates as well as graphical techniques. Both these techniques overwhelmingly reject the empirical validity of the PPP hypothesis for Sri Lanka. The results from widely-used unit root tests, however, provide mixed evidence. We attribute these inconclusive results to the low power of the widely-used unit root tests and their inability to account for unknown trends and means in the real exchange rates.