Mean Reversion of the Real Exchange Rate and the validity of PPP Hypothesis in the context of Bangladesh: A Holistic Approach

The real bilateral exchange rates in many countries have recently been found to be non-stationary in nature implying that they do not tend to revert to a long-run mean. Such empirical findings of real exchange rate being non-stationary in the long-run have thrown the well-known, yet now controversial, theory of Purchasing Power Parity (PPP) under fire. This paper aims to add to the few research works on the validity of PPP hypothesis in case of real exchange rate of Bangladesh by undertaking various approaches. We used five important real exchange rates for Bangladesh with its five important partners of international trade. For validating the PPP hypothesis the stationarity of these real exchange rates have been diagnosed. The tests range from the very rudimentary Augmented Dickey Fuller (ADF) and Phillips Perron tests and other univariate unit root tests, to the tests which addresses one/more breaks in the time series data and finally panel unit root tests that account for the possible presence of cross-sectional dependence in dataset. Such a thorough approach was taken to access the issue of the presence of unit root in real exchange rate in every way feasible, assuming the adjustment process is linear. Almost all the results corroborated each others’ conclusions that the real bilateral exchange rates of Bangladesh with five of its major trading partners are in fact not mean-reverting in the long run and so PPP hypothesis does not hold. Therefore, caution must be practiced when making policies for the country where the stipulated PPP hypothesis is assumed to be accurate.