The Purchasing Power Parity Debate

Topics: Inflation, Exchange rate, Purchasing power parity Pages: 36 (12965 words) Published: March 9, 2011

THE PURCHASING POWER PARITY DEBATE Alan M. Taylor Mark P. Taylor Working Paper 10607 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 June 2004

Forthcoming in Journal of Economic Perspectives. For their helpful comments we thank, without implicating, Menzie Chinn, Richard Clarida, Bradford DeLong, Charles Engel, James Hines, James Lothian, Bennett McCallum, Michael Melvin, Peter Neary, Maurice Obstfeld, Lawrence Officer, David Papell, David Peel, Phillip Lane, Kenneth Rogoff, Andrew Rose, Lucio Sarno, Timothy Taylor, Eric van Wincoop and Michael Waldman. The views expressed herein are those of the author(s) and not necessarily those of the National Bureau of Economic Research. ©2004 by Alan M. Taylor and Mark P. Taylor. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

The Purchasing Power Parity Debate Alan M. Taylor and Mark P. Taylor NBER Working Paper No. 10607 June 2004 JEL No. F31, F41 ABSTRACT Originally propounded by the sixteenth-century scholars of the University of Salamanca, the concept of purchasing power parity (PPP) was revived in the interwar period in the context of the debate concerning the appropriate level at which to re-establish international exchange rate parities. Broadly accepted as a long-run equilibrium condition in the post-war period, it first was advocated as a short-run equilibrium by many international economists in the first few years following the breakdown of the Bretton Woods system in the early 1970s and then increasingly came under attack on both theoretical and empirical grounds from the late 1970s to the mid 1990s. Accordingly, over the last three decades, a large literature has built up that examines how much the data deviated from theory, and the fruits of this research have provided a deeper understanding of how well PPP applies in both the short run and the long run. Since the mid 1990s, larger datasets and nonlinear econometric methods, in particular, have improved estimation. As deviations narrowed between real exchange rates and PPP, so did the gap narrow between theory and data, and some degree of confidence in long-run PPP began to emerge again. In this respect, the idea of long-run PPP now enjoys perhaps its strongest support in more than thirty years, a distinct reversion in economic thought. Alan M. Taylor Department of Economics University of California One Shields Avenue Davis, CA 95616 and NBER Mark P. Taylor University of Warwick United Kingdom

Our willingness to pay a certain price for foreign money must ultimately and essentially be due to the fact that this money possesses a purchasing power as against commodities and services in that country. On the other hand, when we offer so and so much of our own money, we are actually offering a purchasing power as against commodities and services in our own country. Our valuation of a foreign currency in terms of our own, therefore, mainly depends on the relative purchasing power of the two currencies in their respective countries. Gustav Cassel, economist (1922, pp. 138–39) The fundamental things apply As time goes by. Herman Hupfeld, songwriter (1931; from the film Casablanca, 1942)

Purchasing power parity (PPP) is a disarmingly simple theory which holds that the nominal exchange rate between two currencies should be equal to the ratio of aggregate price levels between the two countries, so that a unit of currency of one country will have the same purchasing power in a foreign country. The PPP theory has a long history in economics, dating back several centuries, but the specific terminology of purchasing power parity was introduced in the years after World War I during the international policy debate concerning the appropriate level...
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