On the validity of long-run purchasing power parity: a look at two selected Caribbean economies' exchange rate

A common finding for industrialised economies when the doctrine of purchasing power parity (PPP) has been the subject of empirical investigation is that the results do not support convincingly the prediction of PPP. In light of such findings, this paper empirically examines whether the PPP hypothesis holds up well for two small highly open Carribean economies. Both economies are increasingly reliant on developing service sectors and small industrial bases that are sensitive to external shocks and seasonal affects which may disturb exchange rates from their long-run equilibrium path. We apply tests for long-run PPP using data for the period 1980 through to 1995 by utilising cointergration and error-correction modelling. The results indicate that the monthly data set are wholly consistent with the argument that during the recent floating exchange rate period PPP holds well, at least in a weak form, in small open economies. Possible reasons for this are advanced.