The Joint Tests of the Parity Conditions: Evidence from a Small Open Economy

Abstract

This chapter presents the set of international parity conditions which are core financial theories related to exchange rates determination and joint tests of the validity of Uncovered Interest Rate Parity (UIP) and Purchasing Power Parity (PPP), two important international conditions of parity, for Turkey-US and Turkey-Euro Area within the multivariate-cointegration framework of (Johansen et al., Econometrics Journal 3:216–249, 2000) study, allowing structural breaks such as the global financial crisis of 2007–2009 and implementation of macroprudential policies after the global financial crisis. The cointegration tests statistics reveal two vectors that cointegrate in both systems containing prices, exchange rates, and interest rates for Turkey-US and Turkey-Euro Area for the 2005:1–2009:4 and 2005:2–2010:1 pairs of breaks, respectively. Additionally, for both systems, each parity condition is rejected when it is formulated jointly, which implies that in a financially open economy, asset and commodity market adjustments might be interrelated. Conversely, when each parity condition is formulated as less restrictive for both systems, it is not rejected. This suggests PPP and UIP with proportionality and symmetry conditions in the first and second vectors, respectively.