Relative Purchasing Power Parity Research Articles

Misinterpreting Gustav Cassel Origins and Implications for the Contemporary Literature

This paper puts forward the proposition that Gustav Cassel, the modern originator of the purchasing power parity (PPP) hypothesis, has been misinterpreted and that the theory he suggested is not the theory that is portrayed in the contemporary literature. It is argued that this misinterpretation has led to several pitfalls, including the futile distinction between absolute and relative PPP and viewing PPP as an arbitrage relationship.

Monetary Cooperation in Europe and the Problem of Differential Productivity Growth: an argument for a ‘two-speed’ Europe

Cointegration analysis of a productivity-modified purchasing power parity relation supports the hypothesis that—in the long run—the nominal exchange rate adjusts to accommodate different national rates of productivity growth in the traded goods sector. Accordingly, in the long run, an absence of exchange rate flexibility combined with productivity growth differentials is likely to generate an intractable adjustment problem. Because Germany and France display a similar evolution of productivity, this analysis supports their participation in monetary union, whereas a markedly different pattern of productivity growth in the UK constitutes an argument against membership. In passing, we find empirical support for Michael Porter's hypothesis that continuous devaluation can reduce the rate of productivity growth. This also has implications for UK membership.

International stock return differentials and real exchange rate changes

This article investigates the link between international stock return differentials relative to the US and deviations from relative Purchasing Power Parity. Assuming that the real exchange rate and the relative stock price between two countries contain both permanent and temporary components, we are able to derive a relationship between expected stock return differentials between the same two countries and expected changes in the real exchange rate in terms of observables. The predictions of the model are tested empirically using stock market indices of four major OECD countries relative to the US. The empirical results indicate that there is a negative relationship between stock return differentials against the US and changes in the real exchange rate, i.e. stock markets outperform the US stock market in countries where the currency appreciates in real terms against the dollar.

Real exchange rate targeting and inflation in Turkey: An empirical analysis with policy credibility

In this paper we make an empirical investigation into the conflict among objectives under a real exchange rate policy i.e. between the trade balance and domestic inflation. This occurs when the nominal exchange rate is managed to achieve a certain level of the real exchange rate in order to main external competitiveness. Our empirical analysis draws on the Turkish case, whereby the exchange rate has been the key policy instrument since the 1980s. The results from the simulation experiments with a well-defined macromodel, where the devaluation expectations are explicitly considered, indicate moderate inflationary consequences of a real exchange rate policy based on the relative purchasing power parity (PPP) rule in Turkey. Moreover, a real exchange rate appreciation is found to be contractionary. These are common characteristics of the demand-determined output case. Another major conclusion is that the exchange rate policy can provide an anchor for price stability only if it is credible.

Using a VECM to test exogeneity and forecastability in the PPP condition

The possibility is explored that purchasing power parity (PPP) can be useful in forecasting exchange rates and/or prices. The first step shows that the spot exchange rate is statistically exogenous in the PPP relationship. The next step investigates the forecastability of the variables in the PPP condition. The results show that a VECM can beat a random walk only in the case of the US price level.

Testing for absolute purchasing power parity

Purchasing power parity (PPP) is an equilibrium condition equating the nominal exchange rate between two countries with the relative price of an identical bundle of goods in each country. Previous time-series researchers use price indices to study PPP, so they test relative PPP. We use new data that measures price levels, so we test absolute PPP. Price levels provide a test of absolute PPP because, unlike price indices, price levels do not contain a base period in which the nominal exchange rate equals the price ratio by construction. We find support for absolute PPP.

International real interest rate parity with error correction models

Under costless financial and commodity arbitrage, incorporation of expectational (relative) purchasing power parity (PPP) into uncovered interest parity results in the equality of real interest rates between two nations, which is referred to as International Fisher-open condition. Expectational PPP implies that exchange rates will move to offset changes in price differentials, whereas uncovered interest parity indicates that arbitrage between world financial markets in the form of international capital flows should ensure that the interest differential between any two countries is the unbiased predictor of the future change in the spot exchange rate. As a result, nominal interest rate differential must be equal to expected inflation differential between two countries. This is to say that real interest rates must be identical between two nations, called the Fisher-open condition. Testing the hypothesis that real interest rates for comparable securities are equal across countries is pivotal on the ground that it provides an important implication for exchange rate determination. The results of previous empirical studies, however, are controversial. Howard and Johnson (1983) demonstrated that PPP, the Fisher open condition, and interest rate parity could not simultaneously hold in a world of taxation. Ben-Zion and Weinblatt (1984) and McClure (1988) also provided the same conclusion. Furthermore, Mishkin (1984a) documented empirical evidence rejecting the hypothesis of the equality of real Eurorates across countries. The joint hypothesis of uncovered interest parity and ex-ante relative PPP were also strongly rejected. However, his test for the independency of the Fisher-open condition, the unbiasedness of forward rate forecasts, and ex-ante relative PPP showed few rejections and high marginal significance levels. As a result, his evidence did not rule out that there was a tendency for real rates to be equal across countries over time.

Long-Run Exchange Rate Modeling: A Comment on MacDonald

IN HIS excellent survey of long-run modeling of exchange rates, MacDonald (1995) raises some controversial issues that are frequently encountered in the literature on the extensively researched purchasing power parity (PPP) hypothesis. These issues are: (1) the distinction between absolute and relative PPP; (2) Cassel's PPP and commodity arbitrage; and (3) testing the properties of proportionality and symmetry. This note provides some brief comments on these issues. Let us start with the first issue. Following Frenkel (1978), economists distinguish between the two versions of PPP by specifying the former in levels (MacDonald's equation (17)) and the latter in first differences (the stochastic version of MacDonald's equation (4)). However, if the variables underlying MacDonald's equation (17) (exchange rate and prices) are integrated of order one, and if they are cointegrated, then the equation that supposedly represents relative PPP will be misspecified because it does not contain an error correction term. If an error correction term is included, the distinction will not be between absolute and relative PPP, but rather between long-run and short-run PPP. Moreover, a first-difference specification is problematic because it represents efficient markets PPP under rational expectations. The problem here is that efficient markets PPP predicts that the real exchange rate follows a random walk, implying that conventional PPP does not hold. Hence, an econometrically valid first-difference model should be interpreted to indicate the failure of conventional PPP since the model is based on the assumption that it does not hold.

Mexico's futile attempt to defy purchasing power parity

Many empirical studies have suggested that purchasing power parity (PPP) does not hold in the short run, and some conclude that PPP is not observed even in the long run. The recent collapse of the Mexican peso suggests otherwise, however. This study examines whether PPP has bound the nominal peso/dollar exchange rate and the Mexican and US price levels between 1920 and 1994. Given the long sample period,unit root tests were conducted taking structural breaks into account, but the variables were still found to contain unit roots. Cointegration tests confirm a relationship between the exchange rate and price levels, and an error correction model verifies that it has indeed been the PPP relationship that linked the variables. Deviations from PPP were corrected, on average, within four years. The confirmation of PPP during the period 1920–94 underscores the futility of Mexican policies that defied PPP in the early 1990s, after trade and capital flows were liberalized.

Simple vs. generalized interest rate and purchasing power parity models of exchange rates

We construct a model in which the real exchange rate is affected by the real interest rate and price differentials as well as real factors that cause shocks to the expected flexible-price equilibrium value of the real exchange rate. The model is then employed to test for the “generalized” uncovered interest rate parity and purchasing power parity relations using the data for eight advanced countries and the cointegration technique. Simple versions of the parity conditions are also tested for the purpose of comparisons. We find evidence of cointegration only for the generalized version of the parity relations. Also, out-of-sample forecasts generated from error-correction models indicate that they are more accurate relative to those obtained from a random walk model for half of the countries in the sample.

Instability in short-run adjustments to purchasing power parity: results for selected Latin American countries

According to the theory of purchasing power parity (PPP), there is a tendency toward equalization of different countries' price levels in common-currency terms. However, even assuming that a long-run PPP relationship exists, its relevance for policy makers in less developed countries (LDCs) will depend not only on the average speed of adjustment toward this relationship but also on the variability of such short-run adjustments. We present evidence of extreme volatility in adjustments toward PPP for four Latin American countries, based on time-varying-parameter estimates of error-correction models.

Testing purchasing power parity in a multivariate cointegrating framework

This paper examines a bilateral PPP(Purchasing power parity) relationship between Australia and the 11 major trading countries by means of two alternative econometric techniques-a multivariate cointegrating framework and a band-spectral regression. It is acknowledged that there is no strong evidence that classical PPP holds in all cases. However, the generalized version of PPP holds in all cases, and provides a better explanation of the long-run relations between exchange rates and relative prices.The use of different price indices, i.e CPI and WPI,lead to different estimates and hence different policy implications.

Doctrine of relative purchasing power parity under fixed and flexible exchange rates reconsidered

The doctrine of relative purchasing power parity during periods of fixed and flexible exchange rates is investigated. Using cointegration techniques and data for the Group of Seven countries, a sub...

Long-run purchasing power parity: evidence from some European Monetary System countries

Long-run purchasing power parity (PPP) for five countries participating in the European Monetary System (EMS) during the recent floating exchange rate period is studied. Using new econometric techniques, evidence is found supporting long-run purchasing power parity. Moreover, the long-run PPP relationship is generally stable throughout the period since the dissolution of the Bretton-Woods period, even with the advent of the European Monetary System. Frequent realignments within the EMS may have served to maintain competitiveness between member countries.

Purchasing power parity and real factors

It is acknowledged that purchasing power parity (PPP) fails in empirical tests. The position adopted is that real factors are an omitted variable from the PPP relationship and are the cause of divergences from PPP. The real exchange rate as being determined by supply and demand shift factors (as in Stockman, 1987 and Neary, 1988) is modelled. We then empirically estimate a real exchange rate equation and use the fitted value as a generated regressor in tests of PPP. It is demonstrated that when changes in the real exchange rate are incorporated into the PPP relationship, PPP improves.

Relative PPP in the medium run

This paper tests the relative purchasing power parity (RPPP) hypothesis on month-by-month, post-1972 data, and still obtains regression coefficients that are close to unity. Two methodological aspects have contributed to this encouraging result. Firstly, although all RPPP tests are vis-à-vis the USA, we nevertheless exploit our a priori knowledge about the implications of these USD-based equations on PPP relations between cross-rates. So, in a sense, we use all information implicit in all cross-rates too. Secondly, we selected an instrumental variable that is specifically designed to cope with lead-and-lag effects in non-traded vs traded-goods inflation. Our estimates indicate that most lead-and-lag effects seem to occur within a six-month window. (JEL F31).

Relative PPP and the long-run terms of trade for five Latin American countries: a cointegration approach

This paper uses a cointegration approach with an error correction mechanism to examine purchasing power parity with the US, for Brazil, Colombia, Costa Rica, Mexico and Venezuela. A relative version of purchasing power parity (PPP) is tested which includes the possibility of secularly declining or rising long-run real terms of trade. PPP explains the data fairly well for the more diversified economics of Brazil and Mexico but is rejected for the other three economies.

The Doctrine of Relative Purchasing Power Parity Re‐examined

Investigates the doctrine of Relative Purchasing Power Parity. Mixed evidence is found supporting the concept when using a method analogous to that used by Lucas in testing the quantity theory of money. Relative Purchasing Power Parity is not consistently rejected in the long run between Canada and the United States and between Japan and the United States using quarterly data covering two separate periods: 1957 QI‐1973 QII, and 1973 QIII‐1989 QIV. Given the inconclusive results associated with relying on the methodology of Lucas, considers two alternatives: first, where the requisite smoothed time series are obtained via appropriate autoregressive integrated moving average filters and, second, where cointegration techniques are employed. In these instances, the results are unequivocal. Relative Purchasing Power Parity does not hold.

Co-Integration, Error and Purchasing Power Parity between Canada and the United States

The concept of cointegration and the associated error-correction representation of a dynamic process (see R. F. Engle and C. W. G. Granger, 1987) is applied to the purchasing power parity relationship between Canada and the United States. The results are supportive of purchasing power parity as a long-run equilibrium relationship between the Canadian dollar/American dollar exchange rate. The purchasing power parity relationship is maintained, although with different dynamic mechanisms, during both fixed and flexible exchange rate regimes.

Purchasing power parity as a theory of international arbitrage in manufactured goods: an empirical view of UK/US prices in the 1970s

This study treats purchasing power parity as a theory of arbitrage and seeks to test for its applicability at a disaggregated level. Evidence is found to suggest that arbitrage in individual markets cannot be easily aggregated due to different a adjustment periods across industries. Even at a disaggregated level the evidence does not suggest a long-run arbitrage process of the type implied by relative purchasing power parity. Moreover, the length of time which industries take to adjust to changes in foreign prices and the exchange rate is found to be related both to the domestic competitive environment and the extent to which the particular good is traded.