Abstract
Purchasing power parity (PPP) is an old and controversial proposition in economic literature. It is based on the law of one price, which argues that, after adjusting for the exchange rate, domestic and foreign price levels are equal. The relative version of PPP argues that exchange rate changes depend on the differential between domestic and foreign inflation rates. The absolute PPP version is based on restrictive assumptions that prevent it to hold in the short run. However, several studies support the validity of the relative PPP proposition in the long run. It is often observed that countries with persistently high inflation experience weak currencies. Our empirical testing using impulse response functions derived from a VAR model for eight countries provide mixed results. In six out of eight selected countries, relative PPP is supported by data in the long run.
Highlights
The Purchasing power parity (PPP) is an old proposition in economic literature
Examples are most of the Latin American countries
Countries like Switzerland, Germany, Japan and the Netherlands with historically low inflation have maintained strong currencies. This observation is supportive of the relative version of PPP, which argues that in the long run, exchange rate changes are depended on inflation differential
Summary
The Purchasing power parity (PPP) is an old proposition in economic literature. It argues that exchange rates and price levels, move in the same direction leaving the real exchange rate unchanged. PPP is based on restrictive assumptions that prevent it from holding in the short run. Many studies that support validity of the PPP in the long run. It is observed that many countries with persistently high inflation experience weak currencies, for example, many Latin American counties with very-high inflation were faced with devaluation and depreciation of their currencies. Several western European countries such as Germany, Switzerland and Denmark with stable prices have experienced strong currencies
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