Review On The Theory Of Purchasing Power Parity Finance Essay

An apprehension of Buying Power Parity is indispensable to measure the economic wellness of states and to do the first comparing among different states. The basic theory is that the monetary value of same goods between different states should be equal when the monetary value of goods are measured in a common currency.1 PPP has an of import function in the international finance. First, PPP is a good tool to change over some economic indexs around the universe and it besides provides a point of mention for these states to be compared. Second, PPP theory can be used as an of import measuring and footing to measure the current existent exchange rate.Actually, the current exchange rate ever fluctuate around the PPP rate.So when we compare these two exchange rate, there have been both significant and drawn-out divergences from PPP rate. 2

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The note will supply the reader a wider apprehension of how the construct of palatopharyngoplasty perform, the practical econometric trials of PPP, restrictions about PPP theory.

The literature reappraisal on econometric trials of PPP

The empirical grounds on PPP is immense, so it is wise to split these empirical grounds into six different groups: the early empirical literature on PPP ; trials of the random walk hypothesis for the existent exchange rate ; cointegration surveies ; long span surveies ; panel informations surveies and surveies using nonlinear econometric techniques.

The early empirical literature on PPP, in the early literature, people tested PPP based on the ordinary least squares, but economic experts found that there were a serious job, that is if nominal exchange rates and monetary value indices are nonstationary variables, the proving based on OLS is invalid ( Granger and Newbold,1974 ) . Until the mid 1980s, with the development of advanced econometric techniques, the research on PPP theory and its relationship with existent exchange rate make new advancement. Including these, the trials for a unit root in the existent exchange rate and cointegration trials are most widely used.

As to the trials for a unit root in the existent exchange rate, it is used to prove the stationarity of the informations of clip series. When the information of existent exchange clip series shows nonstationary, it do non back up buying power para theory.Conversely, if it displays stationary, we can believe that the existent exchange rate can return to the average value in the long term, it can besides return to the long-run equilibrium value at last. Lothian and Taylor ( 1993 ) used the unit root to prove Dollar-Pound rate and Pound-French franc rate over 200years.It proved that the trial support the buying power para in the long term. Frankel ( 1987 ) used the unit root to prove the existent exchange rate of Pound-Dollar rate.when the sample periods are 1973-1984 or 1945-1984, it can non reject the random walk hypothesis.when the sample period is 1869-1984, it can reject the random walk hypothesis, and the existent exchange rate return back the buying power para at a rate of 14 % per twelvemonth.

Another manner is to prove the cointegration of the variable sequence of existent exchange rate.For illustration, we can prove the relationship of nominal exchange rate, the monetary value indices expressed in the domestic currency and the monetary value indices expressed in footings of foreign currency.In general, we can corroborate that the existent exchange rate is stationarity when it exists the relationship of cointegration. In this twenty-four hours, the cointegration surveies support the long -run buying power para at the province of the acceptance of generalised natation.

xu ( 2003 ) states that the importance of taking the right monetary value index in PPP trials. In his survey, it shows that the half -life of divergence from PPP is lower than Rogoff ‘s three-five-years. Kim ( 1990 ) utilize EG-test to prove whether arrested development remainders of buying power para exists the unit root. It shows that if sweeping monetary value indices are used, the existent exchange rate are all stationarity for the five industrialized country.But when the consumer monetary value indices are used, merely one exchange rate is stationarity.

Constructing the theory of buying power para

The theory of buying power para derive from the jurisprudence of one monetary value. To better understand of the theory of buying power para, we should cognize about the jurisprudence of one monetary value and discourse the constructs of absolute buying power para and comparative buying power para subsequently.

Without the restriction of conveyance costs and other barrier to merchandise and with a competitory market, the monetary value of same goods in different states will be same one time the monetary value is measured in a common currency.

The most celebrated application of the jurisprudence of one monetary value is the MCDonald ‘s Big Mac. The magazine launched a study of Big Mac index.they choose beefburgers because they fit the construct of the theory of buying power para

Assume that the monetary value of the beefburger in the USA is P $ , so the same beefburger in other states is Pˆ . Harmonizing to the jurisprudence of one monetary value, we can acquire the equation as follows:

Pˆ =E* P $

Tocopherol is the exchange rate between other currencies/dollar. It easy can compare the monetary value of the beefburger to obtain the measurings of overestimate or undervaluation of the dollar in footings of the theory of buying power para against other currencies.

Absolute Purchasing Power Parity

Absolute PPP assert that the monetary value of goods in one state when comparison with the monetary value of the same goods in another state one time measured in a common currency, the monetary value should be equal.For case, if the monetary value of goods is a‚¤50 in the UK, and the same goods is $ 100 in the USA, so the exchange rate will be a‚¤50/ $ 100=a‚¤0.5/ $ 1, the equation can be displayed as follows:


Where S is the exchange rate, P is the monetary value of goods displayed in the domestic currency, P*is the monetary value of same goods expressed in the foreign currency.

In footings of absolute Buying Power Parity, a autumn in the domestic monetary value relation to the other monetary value will give rise to a grasp of the domestic currency compared with the foreign currency.

Relative Purchasing Power Parity

In the absolute version of Buying Power Parity, we assume that at a province of without conveyance costs and other barriers to merchandise and in the presence of a perfect capital and goods markets.

But in fact, conveyance costs and other barriers to merchandise will ever be. Relative theory assert that the exchange rate will set by the figure of the rising prices in different states, which can be expressed as follows:

% a?†S= % a?†P- % a?†P*

Where the left side means the per centum alteration in the exchange rate, the right side means domestic and foreign rising prices rate severally.

Restrictions to the theory of PPP

There are two chief defects around the theory.firstly, the defect of the theory itself. Second, the job about the trial itself.

The restriction to the theory of PPP

On the one manus, the theory assert that the fluctuation of the exchange rate depend upon the purchase power of two currencies, viz. monetary value affects exchange rate merely, and other factors have no direct influence on the exchange rate. But the fact is non the instance, the alteration of many macroeconomic factors can impact the fluctuation of the exchange rate, such as money supply, Interest rate, financial policy, balance of payments etc. Apart from these factors, psychological factor, political relations and struggle have an of import influence on the fluctuation of the exchange rate.It is uncomplete to see the monetary value as the lone factor of the exchange rate.

On the other manus, the velocity of the monetary value to external impact is much slower than monetary value to fiscal markets, so the exchange rate would departure from monetary value in reality.when the minute see the of import economic information is declared, the minute see the exchange rate going from purchase power parity.the monetary value can non catch up with the exchange rate in clip. With the extension of clip, the spread between the monetary value and the exchange rate will be narrowed.So the random consequence of comparative monetary value appear less important.This is the ground PPP can keep in the long tally.

The proficient jobs of the trials

First, the theory of PPP demand the same monetary value system to do certain the comparing of the two states. But in fact, many grounds lead to the hapless comparing between two states, such as economic system, economic construction etc.A figure of empirical grounds show that the pertinence of PPP is reasonably good within the industrialised states, particularly in the members of the European Union.the pertinence is much worse between the industrialised states and the underdeveloped states.

Second, there are many right monetary value index in PPP tests.As mentioned above, IMF have six indices.PPP is much more likely to keep if one uses a tradables monetary value index ( TPI ) , than if sweeping monetary value indices ( WPI ) are used ; much worse is consumer monetary value indices ( CPI ) .

Third, as for the statistical methods, they differ from each state, which chiefly display in trying method and the finding of weights.In pattern, these factors can impact the comparing between two states to some extent.It may take to the different consequences due to different statistical methods.

Fourthly, another job in proving for PPP is the pick of the basal period. If the exchange rate can non reflect the purchase power para between two states at that clip, the trial will do no sense finally.In fact, we can non do certain whether the exchange rate of the base period is sensible or non, so we can acquire different consequences when we choose different base periods.

At last, the finding of monetary value accommodation slowdown and clip periods can impact the consequences of the test.because different states exist assorted differences, different states have different actions on the external shock.for the industrialised states, because they own developed capital and goods market, they can interchange points and service freely and rapidly. The slowdown of the monetary value accommodation in these states will be much shorter than opposite number in those underdeveloped states. We besides can acquire different consequences due to different clip periods. We can happen the large differences by proving on a monthly informations, quarterly informations and annually data.In general, if we test the theory of PPP on a annual information, the spread about monetary value accommodation slowdown between the developed states and those developing states will be narrowed. So it is veryimportant to find clip periods, which can impact the consequences of the trial well.


In a word, there are a figure of literatures about buying power para, and there are besides a assortment of methods and consequences of econometric tests.Most of consequences can non keep the theory of buying power parity.Even though, the value of the theory and prognosis in the long term are widely concerned.especially when a state is at the province of high rising prices, after that, the theory of buying power para will go the of import footing of assorted fiscal policy in these countries.It is indispensable to understand that buying power para is a utile tool that evaluate the wellness of economic sciences and the current province of assorted countries.Just like the same tool and indices, we must cognize the restrictions and take steps to cover with these failing and restrictions.


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