International finance

International Finance

2006

Purchasing Power Parity (PPP

Purchasing power parity (PPP ) is one of the most significant theoretical concepts in international economics . Empirical work on the typically uses time series data to compare the percentage changes in bilateral exchange rates with inflation differentials . Several studies have been based on short or medium-length time series , frequently consisting of post-1973 observations for some major industrialized countries . They usually did not find tough evidence of PPP . The consensus has materialized from this literature that there is in fact a moderate tendency for

real exchange rates to converge towards a long-run equilibrium . Concerned regarding not enough power in their tests researchers then turned to longer time samples . With these , the evidence has swung back in favour of a few long-run tendencies toward PPP . The half-life of PPP deviations seems to be around four years . The long samples required for statistical importance are unavailable for most currencies , conversely , and may be inappropriate because of regime changes

The theory of Purchasing Power Parity states that spot exchange rates between currencies will change to compensate for the differential in inflation rates between countries (Taylor , 2002 . A theory declaring that over the long term the exchange rate between two currencies adjusts according to currencies ' relative purchasing power . In other words , the exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency . For instance , a candy bar that sells for CAD 2 .00 in a Canadian city should cost USD 1 .50 in a U .S . city when the exchange rate between Canada and the U .S . is 2 .00 CAD /USD (Both candy bars cost USD 1 .50

The Purchasing Power Parity (PPP ) theory can be stated in various ways but the most general representation links the changes in exchange rates to those in relative price indices in two countries

Rate of change of exchange rate Difference in inflation rates

The relationship is derived from the basic idea that , in the absence of trade restrictions changes in the exchange rate mirror changes in the relative price levels in the two countries . At the same time , under conditions of free trade , prices of similar commodities cannot differ between two countries , for the reason that arbitragers will take advantage of such situations until price differences are eliminated This "Law of One Price " leads logically to the idea that what is true of one commodity should be true of the economy as a whole the price level in two countries should be linked throughout the exchange rate and thus to the notion that exchange rate changes are tied to inflation rate differences

The theory of absolute PPP claims that the prices in two countries are identical in terms of few single currencies

Et Pt /P t (1

et pt -

t (2

Hence , exchange rate (Et ) should be equal to the ratio of domestic (Pt and foreign prices (P t , equation 2 in logs . It should adjust towards...