PURCHASING POWER PARITY

Critically Evaluate the Empirical Evidence Available on the PPP Theory

Critically Evaluate the Empirical Evidence Available on the PPP Theory

Introduction

The paper discusses theory of purchasing power parity (PPP) in an economic context by collecting empirical evidences from literature. The paper evaluates collected empirical evidences on the forms of PPP in the short and long term. Finally, the paper draws a conclusion on the useful applicability of this concept in real economies.

Discussion and Analysis

Extensive research work has been done by researchers to ascertain exchange rate behaviour in the long term and short term (Bhanja et. al., 2013, p. 19). However, major consensus has been drawn on the evidence that theory of PPP is effectually applicable to countries that report relatively higher trade rates due to geographically close locations (Sarno et. al., 2013, p. 2). Sufficient evidence has been collected on the fact that PPP and exchange rates have shown reversed deviations, which were both long-lasting and extensive (figure 1, figure 2 and figure 3).

Figure 1: Comparison of PPP and real exchange rate for UK and US (Source: Class Material)

Figure 2: Comparison of PPP and real exchange rate for US Dollar and Dutch Mark (Source: Class Material)

Figure 3: Comparison of PPP and real exchange rate for Japanese Yen and Dutuch Mark (Source: Class Material)

In the light of the triennial survey (2010, p. 7), turnover of the global FOREX market has shown considerable increase due to an apparent decline in the market volatility (figure 4).

Figure 4: Turnover of the Global FOREX Market (Monetary and Economic Department, 2010, p. 7)

On the contrary, the UK bond rating has been downgraded due to increasing debt burden and weakening growth outlook of medium term government financial instruments. Consequently, there was drop in the value of sterling (figure 5) against Euro. Analysis of empirical evidence promotes PPP, as a valid international parity condition in the long run (Sarno & Taylor, 2002, p. 65).

Figure 5: Drop in the value of Sterling (Global Credit Research, 2013, p. 1)

PPP Theories

According to Rogoff (1996, p. 647), Purchasing Power Parity (PPP) is an empirical proposition that if converted into common currency shall bring national prices on an equitable level. Moreover, Sarno and Taylor (2002, p. 65) has defined PPP as an exchange rate that will equate national levels of prices in two countries denoted in an ordinary currency so that purchasing power of currency's one unit will be same in the two economies.

Modern theories of PPP and LOP have analyzed the effect of various impediments and costs and these theories have emphasized the significance of appropriate prices to empirically test PPP and LOP. Modern theories of PPP and LOP have recognized the time value for commodity arbitrage, and they have also recognized nonlinearities created by transportation and transaction costs, trade impediments and information (Pippenger, 2004, p. 9).

Empirical Evidence

Empirical studies on the PPP theory such as Taylor and Peel (2000), Michael, Nobay and Peel (1997), and Sarno, Taylor and Chowdhury (2004) have ascertained a non-linear model for co-integration ...