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Do PPP and UIP Need Each Other in a Financially Open Economy? The Turkish Evidence

İ. Aysun Gökcan and Erdal ÖZMEN

Abstract: This paper investigates the empirical validity of the capital enhanced equilibrium exchange rates (CHEERs) model for the Turkish data. The results of the Johansen cointegration analyses for the variable system containing Turkish and US inflation rates, interest rates, and exchange rate suggest the existence of two stationary relationships explaining the long run evolution of Turkish interest rates and inflation rates, respectively. The results of the structural model obtained by data-acceptable over-identifying restrictions over the cointegration space suggest the non-rejection of the hypothesis that the first vector contains uncovered interest parity (UIP) and the second vector contains purchasing power parity (PPP) with proportionality and symmetry conditions. Consistent with the CHEERs approach, each of the international parity hypotheses is strongly rejected when formulated independently. This is a theory-consistent result for a financially open economy for which equilibrium conditions of asset and commodity markets may not be independent of each other.

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