Question

Explain the theory of Purchasing Power Parity (PPP). Discuss the validity of PPP using any empirical evidence you are aware of. (in 1500 words)

Answer 1

Hi,

Here is my view on Topic about PPP.

Purchasing power parity (PPP) is an economic theory of exchange rate determination. It states that the price levels between two countries should be equal.This means that goods in each country will cost the same once the currencies have been exchanged. For example, if the price of a Coca Cola in the UK was 100p, and it was $1.50 in the US, then the GBP/USD exchange rate should be 1.50 (the US price divided by the UK’s) according to the PPP theory.

However, if you were then to look at the market exchange rate of the GBP/USD pair, it is actually closer to 1.25. The discrepancy occurs because the purchasing power of these currencies is different. As with any asset, there is the real value of a currency and the notional value, which financial markets trade at. The aim of the PPP measurement is to make comparisons between two currencies more valid, by adjusting for local purchasing power differences.

PPP measures are widely used by global institutions, such as the World Bank, United Nations, International Monetary Fund and European Union.

The economic theory is often broken down into two main concepts:

1. Absolute purchasing power parity
2. Relative purchasing power parity

1. Absolute parity

Absolute purchasing power parity (APPP) is the basic PPP theory, which states that once two currencies have been exchanged, a basket of goods should have the same value. Usually, the theory is based on converting other world currencies into the US dollar.

For example, if the price of a can of Coca Cola was $1.50, APPP would suggest that a can of Coca Cola in any other country should cost $1.50 after you’ve converted USD into the local currency.

If this does not hold true, then APPP suggests that the currency exchange rate will change over time until the goods are of equal value – as without any barriers to trade, there should be an equilibrium in the price of goods. This is a completely price-level theory, which only looks at the exact same basket of goods in each country, with no other factors included.

However, the theory ignores the existence of inflation and consumer spending, as well as transportation costs and tariffs, which can impact the short-term exchange rate. Without these inclusions, a currency’s power is poorly represented.

2. Relative parity

Relative purchasing power parity (RPPP) is an extension of APPP and can be used in tandem with the first concept. While it maintains that the value of the same good in different countries should equal out over time, RPPP suggests that there is a correlation between price inflation and currency exchange rates. It looks at the amount of a good or service that one unit of currency can buy, which can change over time as inflation rates alter. The theory suggests that inflation will reduce the real purchasing power of a currency, so in order to properly adjust the PPP, inflation must be taken into account.

For example, if the UK had an annual inflation rate of 2%, then one unit of pound sterling would be able to purchase 2% less per year.

One we add this concept onto APPP, we can see that inflation rates will account for part of the change in the power of currencies. So suppose that the UK has a 2% inflation rate, while Brazil has a 5% inflation rate. This means that after one year, the price of a basket of goods in Brazil has increased by 5%, while the same basket of goods in the UK has only increased by 2%

Purchasing Power Parity: The Empirical Evidence

  The empirical validity of PPP has been tested for a large number of currencies under both fixed and flexible exchange rates. For this purpose researchers have employed a variety of estimation techniques, various model specifications and sample data with varying frequency and time horizons. Evidence on PPP can be classified under the following main headings: (i) evidence from the flexible exchange rates of the 1920s; (ii) evidence from post-Bretton Woods flexible exchange rates; (iii) evidence from the EMS and other European countries' exchange rates; (iv) evidence from the exchange rates of other countries; (v) evidence from long-run data (ignoring changes in exchange rate regimes); and (vi) evidence on the 'augmented' PPP. Obviously, overlapping in this kind of classification is inevitable.

EVIDENCE FROM THE FLEXIBLE EXCHANGE RATES OF THE 1920S

The early 1920s is a fascinating period for economists because it marks the first experiment with floating exchange rates for which appropriate data are available. It is extremely important to examine how foreign exchange markets functioned over the period of flexible exchange rates of the 1920s. However, this experience of floating exchange rates was relatively very short, beginning in February 1920 and ending in December 1926. This period encompasses experience of hyperinflationary conditions (the German hyperinflation) as well as normal conditions (the experience of the United Kingdom, the United States and France). Leaving aside the earliest work,' Frenkel (1978) and Krugman (1978) were the first to test the validity of PPP using the data set of the 1920s float. Both of these studies employed conventional regression analysis to test PPP in a bivariate framework and used the CochraneOrcutt procedure to correct for serial correlation? Frenkel (1978) tested PPP in levels and first differences for two dollar exchange rates and one cross rate using three price indices over the period 1921 :2-1925:5and found results which were generally supportive of PPP. In another study employing similar tests on three sterling rates and one French franc rate against the dollar, Frenkel (1981a) found results lending strong support to these findings. However, the results obtained by Krugman (1978) were in direct contrast with Frenkel's findings. He tested PPP using monthly data on three dollar exchange rates and found results indicating the rejection of one-to-one correspondence between exchange rates and relative prices. Conducting similar tests of PPP in levels and first differences for some Swiss franc exchange rates, Junge (1984) found the results for two rates to be roughly comparable with those obtained by Frenkel (1978, 1981a). However, he cast some doubt on the adequacy of PPP for the Swiss franc rates when he compared the results of the first-difference equations obtained by instrumental variables with those obtained from equations in levels. Therefore, he speculated that Frenkel's (1978, 1981a) findings would also weaken the case for PPP in the 1920s for this sample of currencies. This conclusion also finds support in Krugman's (1978) investigation of PPP.

Using the same exchange rates as Frenkel (1978) over the same sample period, MacDonald (1985a) tested the prediction of the efficient market version of PPP that the real exchange rate follows a random walk and found results strongly favourable to ex ante PPP. The results indicated that deviations from PPP did not follow a simple random walk but rather a random walk with an added moving average adjustment, supporting the view of non-stationary real exchange rates. Edison (1985) also challenged Frenkel's (1978) findings on the grounds that he employed conventional tests which suffered from econometric inadequacies. She re-examined the three exchange rates found in Frenkel (1978), employing the general-to-specific methodology, and obtained results which were in direct contrast with Frenkel's (1978) findings. The main conclusion that emerged from this study is that PPP did not hold for two of the three exchange rates. Moreover, while the data did not support proportionality for the pound, symmetry was not rejected in all cases. This apparently conflicting evidence was reconciled by Taylor and McMahon (1988) by effectively abstracting from the consideration of short-run dynamics. Using the data set found in Frenkel (1981a) and employing the Engle-Granger (1987) test for cointegration, they obtained evidence strongly supportive of long-run PPP. They also tested the hypothesis that the real exchange rate followed a random walk. With the exception of the dollar-sterling exchange rate, for which they found rather mixed evidence, their results confirmed PPP as a long- term Oriented.