Applied Economics

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Does the law of one price hold in a high-inflation

environment? A tale of two cities in Turkey

Sule Akkoyunlu & Boriss Siliverstovs

To cite this article: Sule Akkoyunlu & Boriss Siliverstovs (2014) Does the law of one price hold in
a high-inflation environment? A tale of two cities in Turkey, Applied Economics, 46:26, 3236-3245,
DOI: 10.1080/00036846.2014.925190

To link to this article: https://doi.org/10.1080/00036846.2014.925190

Published online: 03 Jun 2014.

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Applied Economics, 2014
Vol. 46, No. 26, 3236–3245, http://dx.doi.org/10.1080/00036846.2014.925190

Does the law of one price hold in a

high-inflation environment? A tale of
two cities in Turkey
Sule Akkoyunlu and Boriss Siliverstovs*
KOF Swiss Economic Institute, ETH Zurich, Weinbergstr. 35, 8092 Zurich,
Switzerland

This study addresses the price convergence in two cities in Turkey (Istanbul and
Ankara) using annual data over the three-quarters of the twentieth century (1922–
1998), characterized by prevailing high inflation rates for most of the period. In
contrast to the rest of the literature addressing convergence in price levels with a
typical result of extremely slow convergence rates at best, we argue that conver-
gence is much easier detected in growth rates rather than levels of prices. We
suggest using the bounds testing procedure of Pesaran et al. (2001) for this
purpose. We find a clear-cut evidence on the existence of a common driving
force behind inflation dynamics in Istanbul and Ankara – a finding that is in
contrast with the results typically reported in related literature.

Keywords: price convergence; structural breaks; bounds testing procedure

JEL Classification: C22; C32; C52; E31

I. Introduction the effects of shocks to real exchange rates diminish over

Purchasing power parity (PPP), conveying an intuitively
appealing argument that national price levels once con-
verted to a common currency should be the same, is a topic
that attracted a lot of attention in the economic literature
for a long time. Frenkel (1978) provides a comprehensive
review of the origins of the PPP doctrine, widely acknowl-
edging the contribution of the Swedish economist Gustav
Cassel to popularization of the PPP hypothesis in the
1920s (Cassel, 1921, 1922).
Since the introduction of unit-root (Dickey and Fuller,
1979) and cointegration (Engle and Granger, 1987) con-
cepts, much of the research on PPP applied unit-root and
cointegration tests in order to determine whether real
exchange rates are best characterized either as mean sta-
tionary or as random-walk processes. Empirical evidence
supporting stationarity of real exchange rates implies that
time. Hence, deviations from PPP of national price levels
are of transitory nature.
A thorough summary of the earlier literature on testing
the PPP hypothesis can be found in Froot and Rogoff
(Froot and Rogoff, 1995) and Rogoff (1996).
Summarizing their observations, Froot and Rogoff
(Froot and Rogoff, 1995, p. 1648) conclude that: ‘[…]
cointegration approaches have sometimes created as much
confusion as clarity on the issue of PPP’. However, they
also point out PPP is not a short-run phenomenon and long
spans of data are necessary in order to find evidence in
favour of it. Also Rogoff (1996) similarly suggests that
PPP finds at best only a limited support in empirical
literature. This prompted Rogoff (1996) to announce the
PPP puzzle in his seminal contribution.
In order to abstract from such issues like prevailing
trade barriers, exchange rate volatility, sticky nominal

*Corresponding author. E-mail: siliverstovs@kof.ethz.ch

3236 © 2014 Taylor & Francis

Does the law of one price hold in a high-inflation environment?
wages and prices that can serve as a potential explanation
for reported difficulty in detection of PPP as well as an
extremely slow convergence to PPP observed at the inter-
national level, more recent literature investigated price
convergence at the city/region level within a common
economic space involving a common currency and the
absence of trade barriers. For example, Chen and
Devereux (2003) applies the augmented Dickey–Fuller
(ADF) test for testing for unit root in relative city price
levels or ‘city real exchange rates’ in 19 US cities over the
period 1918 to 2000. The null hypothesis of unit root is
rejected in six out of 19 cases at the 5% significance level.
When using the 10% significance level, the rejection rate
increases to 11 out of 19 cases. Moreover, Chen and
Devereux (2003) observe that the estimated convergence
speed in the intranational data is slower than that typically
reported in international data, which becomes another
puzzling result added to the existing literature on PPP.
Empirical literature responded in several ways, attempt-
ing to find a solution to this puzzling outcome. First,
referring to a rather low power of the ADF test,
Cecchetti et al. (2002) apply panel unit-root tests sug-
gested in Levin and Lin (1993) and Im et al. (2003) in
order to test the null hypothesis of unit root in relative city
price levels of 19 major US cities over the period 1918 to
1995. As it is commonly argued that by pooling the data,
one typically gains in power when statistically testing the
unit-root hypothesis. Even though Cecchetti et al. (2002)
are able to reject the null hypothesis of unit root in city
price differentials, they similarly report a puzzling evi-
dence that the pace of convergence among city prices in
the United States is much slower (about three times) than
the convergence rate typically found in cross-national
studies. Culver and Papell (1999) also apply panel unit-
root tests for PPP testing not only in the price level data for
United States but also for Canada and several countries of
the EU. They report a striking result that there is a much
stronger evidence of PPP in the EU data rather than in the
US and Canadian data sets.
Second, Sonora (2008) uses more powerful univariate
unit-root and cointegration tests in order to test the PPP
hypothesis and provide alternative estimates of the con-
vergence speed in the city real exchange rates, using
practically the same data set as in Cecchetti et al. (2002).
As reported in Sonora (2008), although the unit-root
hypothesis is rejected as before in Cecchetti et al.
(2002), the estimated speed of convergence is only
slightly faster than in Cecchetti et al. (2002).
The next generation of papers proposed that a typical
finding of puzzlingly slow convergence – or even its
absence – between price levels in different geographical
markets could be explained by an improper modelling of
the underlying time series. Most of the applied research
investigating the law of one price typically fails to account
for the presence of structural breaks, leading to spurious
3237
finding of high persistence (nonstationarity) of relative
prices, which as implied by PPP should be stationary;
see Perron (1989) for consequences of unmodelled struc-
tural breaks on unit-root test outcomes. Sonora (2009)
applies Zivot and Andrews (1992) and Clemente et al.
(1998) unit-root tests that account for the existence of
possible structural breaks in tested time series using a
longer version of CPI data set for major US cities than
one used in Cecchetti et al. (2002). As a main result,
Sonora (2009) argues that city relative prices can be
described as stationary but containing structural breaks.
An additional important finding is that when accounting
for structural breaks, the estimated convergence rates are
of a smaller magnitude reported when using panel unit-
root tests. Similar conclusions are also reported in other
studies which account for structural breaks when addres-
sing relative price convergence among the US cities
(Basher and Carrion-i-Silvestre, 2009, 2011; Hegwood
and Nath, 2013).
Rather than looking for innovative econometric techni-
ques, one alternative is to look for empirical support of
PPP in countries experiencing radically different eco-
nomic conditions, for example, from those prevailing in
the United States. Sonora (2005) applies both univariate
(the ADF test) and panel (Levin and Lin, 1993; Im et al.,
2003) unit-root tests for testing convergence in relative
city price levels in Mexico. The city CPI data for 34
Mexican cities available over the period from 1982 until
2000 are used in the analysis. During the period of inves-
tigation, Mexico was a high-inflation country with a mean
annual inflation of 33% over the whole period.
Nevertheless, the results support convergence in relative
price levels, which is much faster than that recorded in the
US cities in Cecchetti et al. (2002). Sonora (2005)
explains this fact that in the high-inflation environment,
menu costs for adjusting prices are quickly absorbed by
rapidly rising prices, providing incentives for quick price
adjustments.
In this article, we suggest another alternative approach
to testing PPP while dealing with several problematic
issues highlighted above. There are several features of
our approach that are worth emphasizing. First, consistent
with the remark of Froot and Rogoff (1995) that PPP is not
a short-run phenomenon, we use, as an illustration of our
approach, long time-series data on prices collected at the
annual frequency for two Turkish cities (Ankara and
Istanbul) for the period covering 1922 till 1998. The
period in question spans about three-quarters of the twen-
tieth century, allowing us to focus on a truly long-run
relationship between these two price indices. Several per-
iods of very high inflation rates make our exercise more
interesting as it allows us investigate whether the law of
one price held also in such high-inflation environment. An
additional benefit of using the long time series is that it
helps us reconsider the conclusion reached in Özcicek
3238
(2007), where the intraregional price convergence among
19 Turkish provinces is investigated for the period
1994:01 to 2003:12. To the best of our knowledge,
Özcicek (2007) is the only study that investigates intrana-
tional PPP for Turkey. Özcicek (2007) finds no evidence
of price convergence on the basis of univariate and panel
unit-root tests.
Second, instead of looking for convergence among
price indices, we opt for testing whether the law of one
price holds for growth rates of prices or inflation. Thus,
our approach of testing for price convergence is consistent
with the relative PPP hypothesis described in Frenkel
(1978, 1981), where in the international context changes
in exchange rate are related to changes in inflation differ-
ential. In the intranational context with a common cur-
rency, the version of relative PPP reduces to testing
whether there exists a long-run relationship in the form
of inflation differential. Existence of such a long-run rela-
tionship would imply that inflation dynamics is governed
by a common factor whose presence rules out persistent
deviations in inflation in the long run, implying that mar-
kets are integrated and PPP holds in a relative form.
Third, our focus on inflation rather than on price levels
greatly facilitates treatment of structural breaks in time
series under scrutiny.1 These structural breaks are very
likely to occur in our data set as it covers more than
three-quarters of the twentieth century.2 We accommodate
these structural breaks by means of impulse dummies.
Observe that what appears as a spike in inflation translates
itself to a stepwise shift in the associated price level data,
i.e. outliers of a different magnitude observed in inflation
rates result in persistent deviations of price levels, which
are much more difficult to account for and that are likely to
explain the puzzling result of extremely slow (if any)
convergence between price levels that is typically reported
in the relevant literature.
Last but not least, we propose to address the existence
of the law of one price in two distant markets by testing for
the existence of a long-run relationship between inflation
rates by employing the bounds testing procedure of
Pesaran et al. (2001). The advantage of using this proce-
dure is that it can be applied in cases when regressors can
be I(1), I(0) or mutually cointegrated. Furthermore, the
procedure is based on an unrestricted error-correction
model, which permits joint estimation of long- as well as
short-run effects. As pointed out in Banerjee et al. (1998),
joint estimation has better statistical properties than the
S. Akkoyunlu and B. Siliverstovs
two-step Engle–Granger procedure that pushes the short-
run dynamics into the error term.
The use of the procedure of Pesaran et al. (2001) in the
current context also can be supported by the fact that so far
there is no uniform agreement in the literature on whether
(logs of) prices should be modelled as an I(2) or I(1)
process. This naturally has implications for the order of
integration of growth rates of prices or inflation. In the
former case, inflation is also a unit-root process, whereas
in the latter case, inflation, correspondingly, should be
modelled as an I(0) process. On the one hand, a common
observation of a rather high persistence in inflation rates
supports the former view reflected in Banerjee et al. (2001)
and Juselius (1995), for example, where prices were expli-
citly assumed to be I(2) variables. However, treating infla-
tion as a unit-root variable is at odds with economic models
such as the sticky price model of Taylor (1979) or the
Phillips curve model proposed in Calvo (1983), for
instance. On the other hand, Hendry (2001) views the
price level data as integrated of order one (I(1)) with super-
imposed major breaks such that they mimic behaviour of
I(2) processes. As a consequence, inflation is modelled as
an I(0) process with breaks. Romero-Ávila and Usabiaga
(2009) report evidence based on unit-root tests carried out
in a panel data setting, jointly accounting for cross-sectional
dependence and for the presence of unknown number of
breaks that inflation in selected 13 OECD countries can be
considered as an I(0) process with structural breaks. This
finding supports regime-wise stationarity of inflation.
Our main finding is that we provide a clear-cut evidence
concerning the existence of a long-run relationship between
inflation rates in Ankara and Istanbul, supporting an intui-
tively appealing notion of a common driving force behind
price dynamics in these two distant markets in Turkey. Our
finding is in sharp contrast to that reported in Özcicek
(2007). The discrepancy between our findings and those
of Özcicek (2007) can be explained by several factors.
Özcicek (2007) addresses convergence in price levels
using a much shorter sample of data collected at the
monthly rather than annual frequency. In addition, in
Özcicek (2007), no proper accounting for the presence of
structural breaks is made, which is likely to negatively
influence the power of unit-root tests, as discussed above.
The rest of the article is organized as follows. Section II
contains the description of data and its sources. In Sections
III and IV, we describe methodology applied and report
estimation results. Section V concludes.

1
As discussed above, the importance of accounting for structural breaks when testing PPP was already acknowledged in recent literature
(see results of Sonora, 2009; Basher and Carrion-i-Silvestre, 2009, 2011; Hegwood and Nath, 2013, for example). Therefore, it is also
crucial for the approach to testing of the PPP hypothesis suggested in our article that the influence of structural breaks or outlying
observations can be accounted for in a simple and transparent way.
2
For additional evidence supporting the presence of structural breaks in inflation data in Turkey, we refer to Önder (2009). Önder (2009)
estimates Phillips curve for Turkey using a three-regime Markov-switching model. Önder (2009) reports that during the third regime
capturing a high-inflation episode in 1988 as well as two economic crises in 1994 and 2001, similarly characterized by high inflation and
negative output gap, the relationship between inflation and output gap breaks down.
Does the law of one price hold in a high-inflation environment?
II. Data
All the data on price indices come from a single source
Pamuk (2000) and represent a constructed CPI based on a
comparable consumption basket containing both food and
nonfood items compiled from the following sources: data
for the period from 1914 till 1937 are due to Pamuk (2000,
p. 22–23 for Istanbul and p. 58–59 for Ankara), for the
period from 1938 till 1987 – the Undersecretariat of
Turkish Treasury – and for the period since 1988 – the
Turkish Statistical Institute. Due to the fact that there are
no continuous data for Ankara during the period from
1914 till 1922, we restrict our estimation sample to start
from 1922. According to Pamuk (2000), the same base
year 1914 was chosen for both price indices.
In sequel, we will denote the CPI for Ankara and
Istanbul in levels as pA and pI and the corresponding
logarithmic transformation of these two price indices as
ln pA and ln pI. Furthermore, the inflation in Ankara and
Istanbul is denoted as INFA = Δln pA and INFI = Δln pI,
respectively. Both the price indices (in logs) and the cor-
responding inflation rates are displayed in Fig. 1.
The overall impression from Fig. 1 is that there are
certain common features shared by the price indices in
these two cities: relatively stable prices during the 1920s
that even decrease during the pre-Second World War
period, a stepwise increase during the beginning of the
1940s and then further stabilization in the late 1940s. Both
price indices have a tendency to increase since the 1950s,
and, more importantly, this tendency became more pro-
nounced since the late 1970s. The similar dynamics is also
reflected in the pair of inflation time series: a moderate
inflation rate during 1920s followed by deflation in the
pre-Second World War period; a spike in inflation rates
during the beginning of the 1940s, reflected in a stepwise
shift in the corresponding price levels and a relatively
ln PI
15
10
5 5
1920 1940 1960 1980 2000
0.75 INF
I 0.75
0.50
0.25
0.00
1920 1940 1960 1980 2000
Fig. 1. Actual data: price level (in logs) and inflation in Istanbul and Ankara
3239
stable inflation in the post-war period, which started to
increase during the 1950s, and then falling back to the
post-war levels in the 1960s. Both inflation rates display
an upward trending behaviour since the early 1970s with
occasional outbursts, e.g. in the late 1970s and in the mid-
1990s. For a comprehensive review of inflation experi-
ence in Turkey, we direct an interested reader to
Kibritçioğlu (2002).
The difference of log-price levels between Istanbul and
Ankara is displayed in Fig. 2; unsurprisingly, there are
quite persistent deviations to be observed, implying that
the tests for price convergence when applied to price
levels directly are likely to find no evidence supporting
it; see Özcicek (2007) for an example using the Turkish
data. On the contrary, the cross-plot of inflation rates in
Istanbul and Ankara presented in the right-top panel sug-
gests that there is a close relationship between inflation
rates in these two cities. The two lower panels in the same
figure present changes in inflation which look quite similar
aside from the fact that changes inflation in Ankara have
been more volatile in the 1980s than in Istanbul.
All in all, visual inspection suggests that the inflation
rates in Ankara and Istanbul tend to move together, sug-
gesting that these two markets are integrated and react
similarly to common shocks. It remains to see whether
this informal conclusion will be verified by application of
statistical methods.
III. Methodology
In this section, we describe the methodology used for
testing the PPP hypothesis in absolute and relative
forms. The PPP hypothesis in the absolute form
(Frenkel, 1978, p. 177) implies that deviations of the
ln PA
15
10
1920 1940 1960 1980 2000
INF A
0.50
0.25
0.00
1920 1940 1960 1980 2000
3240 S. Akkoyunlu and B. Siliverstovs
ln P I − ln P A 0.75 INF I × INF A

0.2
0.50

0.0 0.25

0.00
−0.2 1927

1920 1940 1960 1980 2000 0.0 0.2 0.4 0.6 0.8

Δ INF I Δ INF A

0.25 0.25

0.00 0.00

−0.25 −0.25

1920 1940 1960 1980 2000 1920 1940 1960 1980 2000

Fig. 2. Actual data: log-price differential (ln pI – ln pA); cross-plot of inflation in Istanbul and Ankara (INFI and INFA); changes
in inflation (ΔINFI and ΔINFA) in Istanbul and Ankara

price level in one location from that in another location
INFtI ¼ α þ θ0 INFt1
I
þ θ1 INFt1
A

should be short-lived, i.e. the log-price differential

X
p1 X
p1
þ λi
INFti
I
þ βi
INFti
A
(3)
i¼1 i¼0
qt ¼ lnðpIt Þ  t Þ
lnðpA (1) 0
þ ω Dt þ υt

should be a stationary variable. Then, the stationarity of

the inter-city log-price differential is tested using the ADF
unit-root test in the following form:
X
n

qt ¼ μ þ ρqt1 þ
qti þ εt
i¼1
The failure to reject the null hypothesis that the variable
qt is an I(1) variable, i.e. H0: ρ = 0, provides no evidence
for supporting the PPP hypothesis. The results of the ADF
test serve as a benchmark in testing whether the PPP
hypothesis holds for these two cities in Turkey.
Next, we describe the bounds testing procedure of
Pesaran et al. (2001) that we apply for testing whether
there exists a long-run relationship between inflation in
Ankara and Istanbul. The bounds testing approach has
broad applicability since the regressors can be I(1), I(0)
or mutually cointegrated. This feature is of a particular
importance in our case, given inconclusive results
reported in the literature on the order of integration of
inflation. Moreover, as discussed above, the structural
breaks are much easier accommodated into the model
estimated for inflation rather than for price levels.
As a starting point for implementing the bounds testing
procedure, we assume that inflation in Istanbul INFI and
inflation in Ankara INFA are related according to a VAR
model of order p that is further reduced to the following
conditional ECM,
The lagged values of INFI and INFA form a long-run
relationship. The deterministic terms such as a constant and
dummy variables are denoted by α and Dt, respectively. The
short-run dynamics is captured by means of lagged values
of
INFtI and current and lagged values of
INFtA . The
(2)
long-run relationship between inflation in Istanbul and in
Ankara is given by the following vector ð1; θ1 =θ0 Þ0
(Banerjee et al., 1998). Observe that if inflation in these
two cities react homogenously to shocks, then the vector of
interest reduces to ð1; 1Þ0 . The bounds testing procedure
uses the conventional F-test for testing the null hypothesis
H0: θ0 = θ1 = 0. Note that this statistic has a nonstandard
distribution which depends upon: (i) the order of integration
of the regressors, (ii) the number of regressors, (iii) the set
of deterministic terms included in the model and (iv) sample
size. Pesaran et al. (2001) provide the set of asymptotic
critical values. We, however, in the hypothesis testing rely
on the critical values simulated in Narayan (2005) for a
sample size comparable to ours.
There are two sets of critical values. The first set gives
the lower bound, applicable when all regressors are I(0).
The second gives the upper bound, applicable when all
regressors are I(1). If the calculated F-statistic falls below
the lower bound, the null hypothesis of no relationship
between inflation in both cities cannot be rejected.
Conversely, if the F-statistic exceeds the upper bound,
the null hypothesis of no long-run relationship is rejected.
As noted above, these critical bounds can be applied
irrespective of the order of integration of the regressors.
Does the law of one price hold in a high-inflation environment?
Finally, if the F-statistic falls within the critical bounds,
the order of integration of the variables must be estab-
lished in order to obtain conclusive inference. In addition,
as argued in Pesaran et al. (2001, footnote 17, p. 307), the
asymptotic theory and the associated critical values must
not be modified provided that fraction of observations for
which one uses dummy variables tends to zero as the total
sample increases.
IV. Results
Application of the ADF test to the log-price differential
from Equation 1 yields the corresponding test statistic of
−1.81, which is compared with the 5% critical value of
−2.91. Thus, we cannot reject the null hypothesis that the
log-price differential between Istanbul and Ankara is an
I(1) variable. This puzzling finding implies that prices in
Istanbul can deviate by an arbitrary large magnitude from
prices in Ankara despite the fact that these two cities share
a common economic space, the same currency, language,
historical and cultural ties.
In presenting the results of testing the PPP hypothesis in
relative form, we start from Table 1. In this table, the results
of the lag order p selection procedure for Equation 3 are
displayed. The information criteria (Akaike, AIC and
Schwarz, SIC) as well as the Lagrange multiplier statistic
testing for remaining autocorrelation up to the first and
second orders in regression residuals are reported. Both
information criteria – AIC as well as SIC – select p = 1.
For all considered values of p, there is no evidence of
remaining autocorrelation in the regression residuals.
Given the results from the selection criteria and the evi-
dence of no residual autocorrelation regardless of the value
of p, the model with p = 1 is preferred. Observe that in order
3241
Table 1. Lag order selection, 1926–1998
P AIC SIC AR(1) AR(2) FHIII0 :θ0 ¼θ1 ¼0
1 −6.256 −6.036 0.772 0.955 57.825***
2 −6.206 −5.924 0.508 0.804 18.653***
3 −6.213 −5.868 0.798 0.522 7.591+
Notes: p is the lag order of the underlying VAR model for the
conditional ECM, see Equation 3. AIC and SIC are the Akaike
and Schwarz Information Criteria, respectively. AR(1) and AR
(2) are the p-values of the Lagrange multiplier test statistics for
testing for residual autocorrelation of orders up to 1 and 2,
respectively. Bold entries indicate the lag order for which the
respective values of information criteria are minimized.
FHIII0 :θ0 ¼θ1 ¼0 denotes the F-test statistic for the null hypothesis
H0: θ0 = θ1 = 0 using the finite-sample critical values reported in
Narayan (2005) for T = 75 corresponding to case III in Pesaran
et al. (2001), i.e. with unrestricted constant and no linear deter-
ministic trend. ‘***’ indicates that the null hypothesis of inter-
est can be rejected at the 1% significance level. ‘+’ indicates that
the test statistic falls inside the bounds (see Narayan, 2005, p.
1988) for T = 75.
1% significance level. For p = 3, the test statistic falls
inside the bounds implying that without further pre-testing
no definite conclusions on the existence of a long-run
relationship between inflation in these two cities can be
reached. This indefinite results is, however, due to fact that
the model with p = 3 is clearly overparametrized as indi-
cated by the values of the information criteria.
Having established the existence of a long-run relation-
ship between inflation in Istanbul and Ankara, we can
estimate the coefficients of interest. Starting with the
error-correction model corresponding to p = 2 and after
deleting the insignificant augmentation lags, we arrive at
the following parsimonious model4:

INFtI ¼ 0:012 þ 0:808
INFtA  0:252 D27t
ð0:007Þ ð0:053Þ ð0:043Þ

to account for the presence of outliers corresponding to the þ 0:156 D27t  0:156 D44t  0:118 D81t
ð0:043Þ ð0:046Þ ð0:049Þ
periods of unusually large discrepancies between inflation
rates in Istanbul and Ankara, the following impulse dum-  I
1:042 INFt1 þ A
1:040 INFt1 þ υt
ð0:092Þ ð0:093Þ
mies (DYYt) have been included in the test regression: D27t,
D29t and D44t each corresponding to the year 19YY.3 R2 ¼ 0:873; Fð7;67Þ ¼ 65:93½0:000;
The corresponding F-test statistic for the joint null ARð12Þ
T ¼ 75; Fð2;65Þ ¼ 0:013½0:986;
hypothesis H0: θ0 = θ1 = 0 using the finite-sample critical
ARCHð1Þ
values simulated in Narayan (2005) for T = 75 correspond- RESET
Fð1;66Þ ¼ 0:070½0:792; Fð1;65Þ ¼ 0:037½0:981;
ing to case III in Pesaran et al. (2001), i.e. with unrestricted
χ Norm
ð2Þ ¼ 0:073½0:964; Fð9;58Þ
Hetero
¼ 0:776½0:651
constant and no linear deterministic trend, is reported in
the last column of Table 1. As seen, the null hypothesis of
no long-run relationship between inflation in Istanbul and where SEs are reported in parentheses and error probabil-
Ankara can be decisively rejected for p = 1 and p = 2 at the ities – in brackets. The model above passes the standard
3
The outliers have been identified as those residuals exceeding regression SE by a factor 2 in the estimated regression (3) with p = 1
without intervention dummies. We also identified a recording mistake (see Pamuk, 2000, p. 59) for the price index in Ankara: the number
13 010 appears both in 1984 and 1985. In private correspondence, S. Pamuk provided us with the correct data for 1984, 8652, which we
use in the current analysis.
4
Observe that in order to account for a moderate outlier in 1981, we inserted an additional impulse dummy for this year in our regression.
3242
specification tests such as tests of no residual autocorrela-
tion, of no residual ARCH effects, of residual normality
and of no residual heteroscedasticity and the RESET test
for functional form misspecification. The overall impres-
sion is that this parsimonious model delivers a satisfactory
fit to data, considering that the period under investigation
that stretches over three-quarters of the twentieth century
is characterized by the Second World War, several domes-
tic political and economic crises, two international oil
crises and major legislative and technological changes.
The estimated model allows us to compare the coeffi-
cients belonging to the lagged inflation variables. These
coefficients are of a similar absolute magnitude with the
implied long-run vector of (1, –0.998)′ such that one can
safely impose a homogeneity restriction θ0 = –θ1, i.e. the
long-run relationship vector between inflation in Istanbul
and Ankara is ð1; 1Þ0 . The restricted error-correction
model is reported below:
S. Akkoyunlu and B. Siliverstovs
to the impulse dummies are estimated with a high degree
of precision. These encouraging results are also supported
by the close match between the actual and the fitted values
displayed in the left-top panel of Fig. 3; the corresponding
cross-plot is displayed in the right-top panel. The esti-
mated regression residuals and their autocorrelation func-
tion up to the ninth order are reported in the same figure in
the left- and right-bottom panels, respectively. Finally, the
results of the Chow tests for recursive stability and the
recursive estimates of the model parameters are shown in
Figs 4 and 5, respectively. In Fig. 4, the values of the one-
step, breakpoint and forecast Chow test statistics are
scaled by their respective 1% critical values (Doornik
and Hendry, 2001). None of the tests show any sign of
model instability.

V. Conclusion

INFtI ¼ 0:011 þ 0:808
INFtA  0:251 D27t
ð0:005Þ ð0:053Þ ð0:043Þ

þ 0:156 D27t  0:156 D44t  0:119 D81t We suggest a novel approach to testing whether the law of
ð0:042Þ ð0:045Þ ð0:047Þ one price holds in the long run between different geogra-
 1:042ðINFt1
I
 INFt1
A
Þ þ υt phically distant markets. Inspired by the relative PPP
ð0:091Þ hypothesis (see Frenkel, 1978, 1981) we suggest to con-
R ¼ 0:873; Fð6;68Þ ¼ 78:06½0:000;
2 duct testing for market integration using growth rates
ARð12Þ rather than levels of prices.
T ¼ 75; Fð2;66Þ ¼ 0:013½0:987; To this end, we propose using the bounds testing pro-
ARCHð1Þ cedure of Pesaran et al. (2001) which can be used in
RESET
Fð1;67Þ ¼ 0:058½0:811; Fð1;66Þ ¼ 0:020½0:887;
situations when there is no consensus in the literature on
χ Norm
ð2Þ ¼ Hetero
0:044½0:978; Fð8;59Þ ¼ 0:810½0:597 the order of integration of the modelled variables. In
particular, it can be used in situations when regressors
Imposing the homogeneity long-run restriction brings can be I(0), I(1) and/or mutually cointegrated. Another
no noticeable changes in the estimated coefficients. As advantage of our approach is that the presence of structural
before, all retained coefficients including those belonging breaks can be much easier addressed when testing for the

ΔINFI Fitted
ΔINFI× Fitted
0.25 0.25

0.00 0.00

−0.25 −0.25

1920 1940 1960 1980 2000 −0.4 −0.3 −0.2 −0.1 0.0 0.1 0.2 0.3
I
1.0 I
2 r:ΔINF (scaled) ACF−r:ΔINF

1 0.5

0 0.0
−1 −0.5
−2
1920 1940 1960 1980 2000 0 5 10

Fig. 3. Actual and fitted values; cross-plot of actual and fitted values; regression residuals (r:ΔINFI); autocorrelation function
of regression residuals (ACF-r:ΔINFI)
Does the law of one price hold in a high-inflation environment? 3243
1.0 1up CHOWs 1%

0.5

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
1.0 Ndn CHOWs 1%

0.5

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
1.0 Nup CHOWs 1%

0.5

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

Fig. 4. Recursive stability one-step, breakpoint and forecast Chow test statistics scaled by their respective 1% critical values

A
0.04 1.0 ΔINF × +/−2SE
Constant× +/−2SE

0.02 0.8

0.00 0.6

1960 1970 1980 1990 2000 1960 1970 1980 1990 2000
−0.1 D1927 × +/−2SE 0.3 D1929× +/−2SE
−0.2 0.2
−0.3 0.1

1960 1970 1980 1990 2000 1960 1970 1980 1990 2000
0.0 D1944× +/−2SE
0.0 D1981× +/−2SE
−0.1 −0.1
−0.2
−0.2
1960 1970 1980 1990 2000 1960 1970 1980 1990 2000
I A
(INF −INF )× +/−2SE
−0.8
−1.0
−1.2

1960 1970 1980 1990 2000

Fig. 5. Recursive estimates of model coefficients

presence of a long-run relationship between inflation rates
rather than price levels in different markets. Intuitively, an
extraordinary large spike in inflation rate in one location
that is unmatched in magnitude in inflation rate in another
location results in an unusually large residual for a single
period when modelling the long-run relationship between
inflation. In this case, its influence can be captured by an
impulse dummy inserted in this particular period. On the
contrary, when testing for convergence in levels of prices,
such a spike translates into a persistent deviation of one
price level from another that has to be captured by a
stepwise shift or an intercept correction which is more
difficult to implement in practice. As the previous research
shows, failure to accommodate structural breaks when
testing for convergence between price levels typically
results in puzzling results of extremely slow (if any) con-
vergence (see Özcicek, 2007, for an example testing for
price convergence in Turkey).
We illustrate our approach by testing whether the law of
one price holds between Istanbul and Ankara using the
inflation time series covering three-quarters of the twentieth
century, from 1922 until 1998. This period is characterized
by the Second World War, several domestic political and
economic crises, two international oil crises and major
legislative and technological changes. Needless to say, dur-
ing most of the period under scrutiny very high inflation
rates prevailed in Turkey. Despite all this, we find a clear-cut
evidence on the existence of a common driving force behind
inflation dynamics in Istanbul and Ankara – a finding that is
intuitively appealing from the point of view of economic
3244
theory. This finding signifies that the economies of these
two cities have been well integrated not only during normal
times but also during periods of high inflation.
Acknowledgements
We are grateful to David Hendry as well as to the partici-
pants at the KOF Brown Bag seminar (Zurich,
Switzerland), the annual meeting of the Swiss Society of
Economics and Statistics (Fribourg, Switzerland), the
EECON Conference (Istanbul, Turkey), the seminar at
the Department of Economics, University of Neuchâtel
(Switzerland), and the EcoMod conference in Ponta
Delgada (Portugal) for their constructive comments. We
also would like to thank Prof. Sevket Pamuk for fruitful
discussions on construction of price indices.
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