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Should the Cr oatian N ational B ank D evaluate the E xchange R ate?

This paper examines the validity of the Purchasing Power Parity (PPP) theory in Croatia and assesses whether the Croatian National Bank should devalue the exchange rate. The study reviews empirical research, presents data analysis and methodology, and discusses policy implications.

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Should the Cr oatian N ational B ank D evaluate the E xchange R ate?

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  1. Should the Croatian National Bank Devaluate the Exchange Rate? Evidence from Purchasing Power Parity Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  2. Content • PPP hypothesis • Review of empirical research • Data • Methodology • Results • Policy implications Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  3. PPP hypothesis • Exchange rate that equates domestic and foreign price levels so that the purchasing power of a unit of one currency would be the same in both economies (Sarno and Taylor, 2001) • One of the most extensively tested theoretical propositions • Intuitive and simple  We wanted to test whether ppp holds in Croatia since the debates about the overvaluation of the nominal hrk/eur exchange rate are quitte common Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  4. Review of empirical research • Consensus concerning the validity of PPP appears to have shifted several times in the post-war period • The prevailing view is that long-run PPP does have some validity, although a number of puzzles have yet to be resolved • For transition countries results seem less conclusive  reasons stem from characteristics of transition economies • Most of transition economies suffered external and internal shocks, high inflation and/or major exchange rate shifts • Nonlinear tests more succesful in detecting PPP for developing countries when compared to linear tests • Croatia: till now authors tested only for linear ppp (unit root, cointegration and panel data tests) contradictory results Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  5. Data • To test the PPP theory we needed: • Monthly average nominal HRK/EUR exchange rate • Monthly Croatian consumer price index • Monthly harmonized index of consumer prices for EMU • All data range from January 2000 to December 2009 Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  6. HRK/EUR Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  7. Croatian CPI Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  8. Eurozone HCPI Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  9. HRK/EUR in first differences Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  10. Croatian CPI in first differences Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  11. Eurozone HCPI in first differences Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  12. Methodology • Two cointegration methods: • Johansen cointegration: symmetry in both the short and long run • Threshold cointegration: asymmetry in short and symmetry in the long run  Enders and Siklos (2001) • Vector error correction models Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  13. Results – Johansen cointegration • Two cointegrating vectors: • Absolute PPP condition • Long run relationship between domestic and eurozone price level Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  14. Results – Johansen cointegration Restrictions: First cointegrating vector: • long run coefficients for the exchange rate should be equal to 1 • long run coefficients for EMU prices should be equal to 1 • long run coefficient for domestic prices should be equal to -1 • in the short runEMU prices are weakly exogenous Second cointegrating vector: • long run coefficients for the exchange rate should be equal to 0 • long run coefficient for domestic prices should be equal to 1 Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  15. Results – VECMs’ Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  16. Results • Absolute power parity holds in the long run • Exchange rate adjusts to deviations from the parity in the short run • Price level in Croatia and the eurozone are weakly exogenous • Higher inflation in Eurozone leads to appreciation of nominal HRK/EUR exchange rate in the short run • No proof of exchange rate pass-through to domestic consumer prices • Adjustments of deviations from the PPP is not asymmetric Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  17. Policy implications • Devaluation is not an appropriate policy response • Nominal rigidity in the economy should be decreased • More nominal exchange rate variability  when no structural characteristics are taken into account * Exchange rate is flexible enough to correct discrepancies in prices; performs its basic economic function Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

  18. Results - TAR and M-TAR Marina Tkalec - Maruška Vizek 16th Young Economists’ Seminar

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