Purchasing Power Parity in the SAARC Region: Evidence from Unit Root Test with Cross-Sectional Dependence

Mixed results on the validity of Purchasing Power Parity (PPP) relationship in South Asian countries motivates this paper to conduct a further inquiry. Existing studies lack appropriate treatment of cross-country dependence in the testing procedure. In this paper we employ a method that allows us to identify the degree of cross-sectional dependence (CSD) and apply panel unit root test to accommodate this dependence on the real exchange rate series of five South Asian countries in the South Asian Association of Regional Cooperation (SAARC) which include Bangladesh, India, Pakistan, Sri Lanka and Nepal. We find evidence of strong cross-country dependence, cross-country correlation being 0.735. Our panel unit test results support the validity of long-run PPP in the sample countries. This result is in contrast to the previous studies in similar countries which did not accommodate CSD in their estimation. This finding implies that real shocks do not have any permanent effect on the real exchange rate and other things remaining the same, no active policy intervention is warranted for the sustainability of external balance.