Purchasing Power Parity

Topics: Purchasing power parity, Exchange rate, Inflation Pages: 9 (2605 words) Published: April 3, 2011

There has been a long standing controversy among the economist about the validity of PPP (Purchasing Power Parity) in the long run. The parity reveals that prices in two different economies should be identical to each other when they expressed in terms of the same currency. It is a central building block in the monetary models of exchange rate determination. One of the most common practices, to test the validity of PPP is through unit root test of real exchange rate. In this paper unit root test has been done based on the data on Bangladesh and its major trading partner India, to see whether exchange rate has unit root or not. It has been found out that the PPP holds i.e. real exchange is not trend stationary in the long run, at a certain significance level. So the null hypothesis that real exchange root has unit root has been rejected. This paper should be seen as an exploratory study on this subject.


The Purchasing Power Parity (PPP) theory, sometimes called the ‘inflation theory of exchange rates’ can be traced back to the Salamanca school in sixteenth century Spain, and in the writing of Gerrard de Malynes which appeared in 1601 in England. Though Keynes gave credit to David Ricardo for the concept of PPP, Swedish economist Gustav Cassel was first to name the theory PPP. After World War I, Cassel became the outstanding protagonist of the theory. He used it in order to estimate the equilibrium exchange rates at which nations could return to the gold standard after the disruption of international trade and the large changes in relative commodity prices in the various nations caused by World War 1. Purchasing power parity (PPP) exchange rate is the exchange rate between two currencies that would equate the two relevant national price levels if expressed in a common currency at that rate, so that the purchasing power of a unit of one currency would be the same in both economies

The question of whether Purchasing Power Parity (PPP) holds in the long run has been the subject of capacious research. The controversial of PPP theory arisen mainly caused by the data-generating process of the variables concerned. Meese and Singleton (1982), in their studies found that nominal exchange rate has a unit root. This means that the series follows a random walk process and its movement is unpredictable. In other words, the level relationship of the series concerned would not be confirmed in both short- and long-run. Since then, the unit root tests such as Dickey Fuller (DF) test, Augmented Dickey Fuller (ADF) test, Phillips Perron (PP) test and the Bayesian unit root approaches have been applied to examine the robustness of the PPP theory. While very few contemporary economists would hold that PPP holds continuously in the real world, “most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates” (Rogoff, 1996). Some of the strongest evidence of PPP holding in long run is provided by Taylor (2002). Theoretical it holds in the long run while it deviates in short run because monetary shocks combined with sticky nominal prices or wages provide an explanation for the short-run volatility of real exchange. In this paper whether PPP holds in the long run is going to be tested based on Bangladeshi context through the unit root test of real exchange rate. To test unit root ADF and DF-GLS method has been chosen. DF-GLS has been recognized by many economists as a more powerful test then ADF.

The necessary data has been collected from the website of IMF and Penn World. The secondary methodology consists of consultation of different research paper, journals, articles and books related to the topic.

The objective of this paper is to through some light in whether or not PPP holds in the long run. But one of the major limitations is that the data size is diminutive; the sample size is only 30, yearly based. This is due to the fact that Bangladesh...
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