Purchasing Power Parity and Cointegration: The Case of Greek Exchange Rates

Abstract

The purchasing power parity (PPP) hypothesis asserts that the equilibrium exchange rate between any pair of currencies is equal to the ratio of domestic and foreign prices (absolute PPP) or that the equilibrium changes in exchange rates match inflation differentials (relative PPP). PPP has been studied extensively and there is consensus that PPP is not likely to hold in the short run (Frenkel, 1981). Whether the relationship holds in the long run is still controversial. Empirical studies of PPP and real exchange rates have found favourable results when the countries examined experienced periods of high inflation (Frenkel, 1978, 1981) or when the period under investigation was of long duration (Abuaf and Jorion, 1990; Kim, 1990). However, empirical studies of the recent floating exchange rate period cast doubt on the hypothesis that the PPP theory holds in the long-run for major industrial countries.1