An Analysis of Purchasing Power Parity using Ricardian Model Regarding Real Exchange Rate, Inflation and Import of Bangladesh with Reference to 1972-2016

Abstract

This paper tests purchasing power parity (PPP) with a version of Ricardian model which hypothesizes that there exists an association between real exchange rate and inflation in Bangladesh. The broad objective of this study is to investigate the causes of change in price of the goods in the case of Bangladesh by employing the Johansen long run testing approach to cointegration. Based on Ricardian model, Johansen long run cointegrating equation is developed for Bangladesh over the period 1972-2016. The Johansen multivariate cointegration technique is used in this paper to test the existence of a long-run equilibrium relationship among the variables such as real exchange rate, inflation and import. The augmented Dickey-Fuller test has been adopted to examine the stationarity, or otherwise, of the time series data. Error correction model (ECM), model is also developed to test the short run dynamics of real exchange rate function. Cumulative sum (CUSUM) and cumulative sum of square (CUSUMQ) have been used to test the stability of the model. The results show that there is a long run relationship among real exchange rate, inflation and import. The results from ECM show that speed of adjustment in real exchange rate function is moderate in Bangladesh. The plots of CUSUM and CUSUMQ indicate the instability of the model. Supportive evidence has been found that real exchange rate, inflation and import might account for deviations from PPP in Bangladesh within the analyzed period. The real exchange rate must respond to a number of real factors in the long run and nominal factors in the short run.

Keywords: Ricardian Model; Purchasing Power Parity; Johansen Long Run Cointegrating Equation; Real Exchange Rate-inflation Association; Instability

Australian Academy of Accounting and Finance Review, vol 3, issue 3, July 2017, pp 111-118