TESTING PPP

Econometric Analysis to Test the PPP in Developing Economies

Econometric Analysis to Test the PPP in Developing Economies

Introduction

The purpose of this paper is to re-examine one of the most controversial theories in international economics - the purchasing power parity (PPP) - for developing countries, using recent advances in econometrics non-stationary dynamic panels. The PPP in its different versions relates the nominal exchange rate of two currencies and the price ratio between an economy and its trading partner. According to this theory, a country where inflation is higher than its trading partners will tend to have a depreciating currency.

Although work often highlights the lack of empirical basis of this theory and its relevance as a reference model to describe the behaviour of long-term real exchange rate is challenged, the PPP is still present in most models for determining the exchange rate. In addition, economic policy, it continues to serve as a framework for defining the level of equilibrium exchange rates and measure the extent of misalignment in developing countries.

Purchasing Power Parity

Purchasing power parity (PPP) is a term of macroeconomic analysis. The purchasing power parity (PPP) is a method used in economics to make a comparison between countries of the purchasing power of national currencies.

The purchasing power of a given amount of money depends on the cost of living, that is to say, the general level of prices. The PPP can measure how much a currency can buy goods and services in each area to be compared.

The currency commonly used as a reference is the U.S. dollar, taken in a given year.

Law of One Price (LOP) and Purchasing Power Parity (PPP)

In a market overall and unified, without transport costs, identical products all have the same prices at the same time and at all places in this market: the law of one price. This law is controversial, it is microeconomic in nature. It is defined product by product, manufactured or not (for example copper, coffee, cement, tires of a given size, the can of Coca-Cola, Big Mac).

The real world provides examples of how much closer to the theoretical situation that the products concerned are more standardised and less expensive to transport. For most products, the assumptions on which it is based are far from being realised: the world is far from being a single market, transport costs are not zero, the regulations differ from country to country, and the tariffs applied to imports are increasing their selling prices.

In addition, manufacturing costs vary widely by country: Some natural resources are more or less abundant, the climate varies, and the cost of labour varies greatly. Prices therefore strongly differ from one place to another.

However we can consider that the consumer of a country realises that some products are more expensive in some other countries and in others they are cheaper.

The Law of Purchasing Power Parity is a law of nature that expresses a macroeconomic cost equal to the basket in all countries with a reasonably comparable standard of ...