Do We Expect the PPP Theory to Hold in Real World - Assignment Example

Do we expect the PPP theory to hold in real world? Discuss. Introduction Purchasing Power Parity (PPP) is quite simply a theory that suggests that nominal exchange rate between two different currencies should be equated with respect to overall price levels between the respective countries, so that a unit of home currency has equal purchasing power in the foreign country. The PPP theory is a measure of determining exchange rate by taking into consideration the relative difference in price level of two different countries for a given period of time. The theory is also known as “Inflation theory of exchange rate” because it singles out the change in price level as a major determinant of exchange rate fluctuations (Taylor, 2002). There is a continuous debate about absolute and relative validity of the theory over a long period of time. Moreover, validity of PPP theory has also been questioned in short and long run. The PPP theory is considered of similar status as that of the Quantity Theory of Money (Pilbeam, 2013). Similar to QT, exchange rate fluctuations caused by monetary disturbances result in frequently deviation of rate from the PPP and adhere to the theory post disturbance. In long run, changes due to financial innovation and/or real income affect one-to-one relationship between price and money supply and also cause PPP deviations (MacDonald, 1993). The essay discusses the relevant models of PPP and associated empirical evidences with respect to practical scenarios. It further discusses relevance of PPP to exchange rate variations and validity of its applications in the real world. Statement of the theory The statement says that suppose Pa and Pa* are the price of ath commodity in the home and foreign country respectively and E is the exchange rate. In addition, it is also assumed the Pa and Pa* are quoted in their respective currencies. Since absolute PPP theory suggests that Law of One Price prevails in an integrated competitive market; Pa = E Pa*. Furthermore, if in place of individual goods, a basket of commodities is considered, where P = f (P1, P2, Pa, .. Pn) is price index in home country and foreign index is given by P* = f (P1*, P2*, Pa*, .. Pn*), even then absolute PPP will prevail. Thus, the exchange rate is obtained by: E = (P/P*) = (Domestic price of a standard basket of commodities/ foreign price of a standard basket of commodities) --------------- (1) During monetary disturbances, price of the common basket of commodities will be measured in a common currency, where P/ E P* =1 will be valid for all time (Taylor, 2002). There is no objection to theoretical implication, but its practical application was questioned several times because when location of commodities is changed, it is affected by transport cost, tariffs, quotas and taxes. Hence, the relative version of PPP was introduced, which determines the exchange rate while considering changes in relative price levels: E = θ P/P*, where θ is a constant, which reflect trade obstacles that affect the price. The impact on cost of commodity, as a result of trade variables, is depicted by: É = Ṕ - Ṕ* ------------ (2) The ´ represents a change in the percentage of price (Sercu, Uppal and Hulle, 1995). The theory of PPP holds valid in case of non-identical products, even if Law Of One Price does not apply, but the condition has to justify homogeneity postulate of monetary theory. According to the homogeneity postulate, a pure monetary disturbance leaving everything unchanged lead to proportionate change in money and prices, including price of foreign exchange. The assumption of a purely monetary disturbance illustrates that once an economy is adjusted, depreciation in exchange rate corresponds to the inflation, which applies to individual or cumulative price of a basket so that the equation (2) applies. The PPP theory through adjustment mechanism can be employed as a theory of equilibrium. For identical commodities, the theory is a function of spatial arbitrage; whereas, in case of non-identical commodities, a certain degree of substitution is assumed so that exchange rate-adjusted price can be determined (Sarno and Taylor, 2001). Empirical evidence on PPP The simplicity and intuitive nature of PPP makes it an attractive theory, but evidences of empirical tests have produced mixed results. A number of economists have rejected the PPP theory after shortcomings were observed during empirical study. There are mainly four approaches to test the PPP theory. The first approach considers simple test of Absolute and relative PPP using the following equations: St = β0 + β1 (Pt – Pt*) ----------------- (3) ∆St = β0 + β1 (∆Pt – ∆Pt*) ----------------- (4) In the above equations, all the variables are in logs and S denotes nominal exchange rate, while P and P* are domestic and foreign prices respectively; the time is denoted by t. The PPP is valid in the above equations, only if β1 is equivalent to 1. When these equations were applied on hyperinflationary countries during 1920s, the results were in support of PPP. However, the same test produced deviated result from PPP when applied on post Bretton Woods era. The main shortcoming of this method is that it does not express a direct causal relationship between exchange rate and price level (Baum, Barkoulas and Caglayan, 2001). The second approach of PPP theory test is based on its long run behaviour and the fact that fluctuation in exchange rate is higher than that in price levels. This method tests the mean reversion of real exchange rate, as an indirect test of the PPP theory. Any kind of mean reversion contributes towards expressing validity of PPP theory and otherwise. The equation used in this test is: ∆Et = α + γEt-1 + ut In this equation, ut is white noise error term. The null hypothesis considers that the real exchange rate has a unit root (γ=0). This approach when applied on industrial countries during floating exchange period resulted in acceptance of the PPP theory. It was also observed that only in case of long horizon data, PPP is supported (Cheung and Lai, 1993). The third approach is co-integration analysis, which was also observed to produce mixed results in testing the PPP theory. The analysis showed that when large-scale samples were employed, results produced were in favour of PPP, but small sample size did not support PPP hypothesis (Pedroni, 2001). The last approach is the panel data analysis. This approach takes in account both time series data and cross-sectional observations. This approach also produced result that supports long-term PPP. In other words, the nominal exchange rate and price levels exhibit long-term equilibrium (Mkenda, 2001). Does PPP hold in the real world? The basic idea behind implementing Purchasing Power Parity is to create equivalence in the national and internal market related to a particular commodity or basket of commodities in terms of their prices. It illustrates that a unit of a currency should be able to fetch same quantity of a particular product in the foreign country as that in the domestic market. The foreign currency considered in the PPP theory is generally the US Dollar. An easy way to determine validity of PPP theory is to compare price of identical products in two different countries. For example, the price of McDonald’s Mac burgers in different countries can be compared using US Dollar as a common currency. This method helps in understanding if a currency was undervalued, overvalued or at the right value at a particular point of time with respect to US dollar (A M Taylor and M P Taylor, 2004). In case of products that are internationally available, PPP theory often holds good as price of any internationally traded goods ought to be same in different locations when converted to a common currency as per the Law of One Price. However, fallacies were observed in this theory because transactional costs such as, tariff cost, taxes, duties and transport cost were not included. It was observed that product price was substantially high or low with respect to other countries due to transactional costs. Hence, in major circumstances, relative PPP holds valid over Absolute PPP (Sercu, Uppal and Hulle, 1995). Nevertheless, when extensive researches were undertaken, it was witnessed that in short run, neither absolute nor relative PPP hold good (Adler and Lehmann, 1983). Both these models were reasonably acceptable when considered with long-term data. Furthermore, it was also noted that PPP has a greater impact on producer price indices than that on consumer price indices. As a result, the effect of relative price level increases over time (Enders and Dibooglu, 2001). Conclusion Since the Bretton-Wood era, PPP theory has been an important subject of debates and discussions. Several theoretical works in this regard suggest that relative change in price is highly related to exchange rate and as a result, the absolute PPP theory was developed. However, application of this theory differed from the original concept by a great degree and it was observed that transactional costs have an influence on PPP as well, which was earlier neglected. The absolute PPP was modified keep in view the transactional cost and the relative PPP theory was established. When tests were conducted and hypotheses were developed to understand implication of different models of PPP theory, it was observed that long-run PPP has an effect on mean reversion of real exchange rate while short-run PPP test produced erroneous and ambiguous result. This observation made many economists to conclude that in real world applications, PPP can be employed only when an activity is seeking long-term equilibrium. In addition, it has also been observed that the relationship between PPP and real exchange rate keep shifting from time to time which thus create scope for further study and research in future. Future researches will also be helpful in determining behaviour of real exchange rate with respect to contribution of price and nominal exchange rate. Reference list Adler, M. and Lehmann, B., 1983. Deviations from purchasing power parity in the long run. The Journal of Finance, 38(5), pp. 1471-1487. Baum, C. F., Barkoulas, J. T. and Caglayan, M., 2001. Nonlinear adjustment to purchasing power parity in the post-Bretton Woods era. Journal of International Money and Finance, 20(3), pp. 379-399. Cheung, Y. W. and Lai, K. S., 1993. Long-run purchasing power parity during the recent float. Journal of International Economics, 34(1), pp. 181-192. Enders, W. and Dibooglu, S., 2001. Long-run purchasing power parity with asymmetric adjustment. Southern Economic Journal, pp. 433-445. MacDonald, R., 1993. Long-run purchasing power parity: is it for real? The Review of Economics and Statistics, 75(4), pp. 690-95. Mkenda, B. K., 2001. “An Empirical Test of Purchasing Power Parity in Selected African Countries - a Panel Data Approach”. [pdf] Goteborg University. Available at: [Accessed 26 May 2014]. Pedroni, P., 2001. Purchasing power parity tests in cointegrated panels. Review of Economics and Statistics, 83(4), pp. 727-731. Pilbeam, K., 2013. International finance. London: Macmillan Publishers Ltd. Sarno, L. and Taylor, M. P., 2001. Purchasing power parity and the real exchange rate. [pdf] Centre for Economic Policy Research. Available at: [Accessed 26 May 2014]. Sercu, P., Uppal, R. and Hulle, C., 1995. The exchange rate in the presence of transaction costs: implications for tests of purchasing power parity. The Journal of Finance, 50(4), pp. 1309-1319. Taylor, A. M. and Taylor, M. P., 2004. The purchasing power parity debate. [pdf] University of California. Available at: [Accessed 26 May 2014]. Taylor, A. M., 2002. A century of purchasing-power parity. Review of economics and statistics, 84(1), pp. 139-150. Read More