Purchasing power parity under high and low volatility regimes

This article adopts Markov switching models to establish and examine several types of nonlinear dynamics in exchange rate returns and provide a new test to analyse presence of purchasing power parity (PPP) after controlling for various market states. In contrast with Engle and Hamilton (1990) focusing on discussing the dual state setting on the first moment of quarterly data for major industrial countries' currencies, we concentrate more on the second moment for monthly data and add an analysis of developing countries' currencies. Our empirical findings are consistent with the following notions. First, volatility-switching behaviours are more (less) remarkable for developing (industrialized) countries' currencies. Second, we denote the high volatility state of exchange markets of developing (industrialized) countries as a crisis (an unusual) condition. Moreover, PPP would be valid at the low (high) volatility state for developing (industrialized) countries.