Abstract
This paper aims to assess whether the purchasing power parity (PPP) holds by examining the dynamic link between nominal exchange rate (NER) and relative consumer price (RCP) in China. With economic transitions and structural changes existing, we discover that by using full sample data the PPP does not hold. Consequently, we apply the rolling window causality method in order to reconsider the dynamic causal link, and as a result we observe NER having both positive and negative impacts on RCP in some sub-periods. However, RCP has no effect on the NER, meaning that the PPP does not hold. Trade cost, restrictions and imperfect competition are considered in explaining the deviations in some sub-sample periods. Therefore, this empirical result has important implications for stakeholders to distinguish factors that bring about the PPP deviations and further offers policy suggestions for the Chinese monetary authority.
Highlights
The intent of this paper is to investigate whether the purchasing power parity (PPP) condition fits for China
Since joining the World Trade Organization (WTO), the trade cost between China and the U.S has been reduced from 35.57% to 27.32%, but this still violates the foundation of the PPP (Kim, 2014)
Considering the structural changes in the full-sample period, the PPP condition does not hold in the long run
Summary
The intent of this paper is to investigate whether the purchasing power parity (PPP) condition fits for China. The PPP condition between nominal exchange rate (NER) and relative consumer price (RCP) is used to measure the long-run equilibrium value of the currency. The PPP offers a basis for evaluating the effectiveness of the foreign exchange market. Vieira, Holland, Silva, and Bottecchia, (2013) reveal that highly fluctuating exchange rates have negative impacts on economic growth. The People’s Bank of China (PBOC) chooses discreet monetary policies when decreasing the negative influence from deviations. The PPP condition between RCP and NER forward premiums or discounts does provide a basis for the evaluation of the effectiveness of monetary policy but offers as well suggestions to promote NER mechanism reform
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