LONG-RUN PURCHASING POWER PARITY AND EXCHANGE RATES: EVIDENCE FROM THE MIDDLE EAST

This paper examines the validity of Purchasing Power Parity and investigates the market integration between Jordan and its major trading partners, namely, Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates. Unit root tests, Johansen co-integration test and a vector error correction model were employed to test data covering the period 2005Q1-2012Q4. The unit root tests demonstrated that all variables were integrated of order one. The results of co-integration tests showed that a co-integrating relationship existed between exchange rates, domestic and foreign price levels for four Gulf Cooperation Council countries. The two remaining countries, Oman and United Arab Emirates, do not have a co�integration relationship. For the vector error correction model, we found the error correction terms for Jordan with the Gulf Cooperation Council countries carried the expected sign. This suggests that whenever there is a deviation from the equilibrium co-integrating relationship, the exchange rate interacts in a dynamic fashion by adjusting to restore its long-run equilibrium. Finally, the models passed all the diagnostic checking. In conclusion, these results provide evidence that the Purchasing Power Parity model holds in the long run. The results also show the Jordanian economy is integrated with six trading countries.