Exchange Rate Economics: Theories and Evidence

40 Purchasing power parity and the PPP puzzle
Chapter 1,the striking feature of this figure is the very close correlation between
real and nominal exchange rates (the correlation coefficient is in excess of 0.9 and
this is a common finding,regardless of the currency studied). As we shall see,
this close correlation immediately calls into question the existence of purchasing
power parity on a continuous,period-by-period basis. However,Figure 1.1 does
not necessarily rule out the existence of PPP as a longer run concept and that is
one of the key aspects of the PPP literature that we try to assess in this chapter and
the next.
The outline of the remainder of this chapter is as follows. In the next section
we consider the PPP concept in more detail,and discuss some important reasons
why it may not be expected to hold in both the short and longer term. Section 2.2
contains an overview of the early empirical literature on PPP,while Section 2.3
contains a review of more recent tests of PPP,which rely on panel unit root and
panel cointegration testing methods. Section 2.4 contains a discussion of the power
of unit root tests and how issues of power have been addressed in the PPP literature.
2.1 Purchasing power parity: traditional PPP versus
efficient markets PPP and the PPP puzzle
2.1.1 Absolute and relative PPP
The starting point of the traditional PPP hypothesis is the so-called law of one
price (LOOP). Consider a two-country world in which the home and foreign
country each produce a homogeneous traded good. Absent any impediments to
international trade,such as transportation costs and tariffs,the LOOP says that
the homogeneous good should sell for the same price in the home and foreign
country,when converted at the market exchange rate:
P i
t = S t P i∗
t ,(2.1)
where P i denotes the price of the homogeneous good i, S is the nominal exchange
rate (home currency price of one unit of foreign currency) and,as before,an asterisk
denotes a foreign magnitude. The mechanism that forces the LOOP condition is
arbitrage. Thus,if the domestic price level is greater than the quotient of the foreign
price level and the exchange rate it would be profitable to ship the good from the
foreign to the home country. The continuation of this process would ensure that
the LOOP was eventually restored (i.e. prices would fall in the home country and
rise in the foreign country).
If it is further assumed that there are n goods produced in each country and
each of these goods has as its counterpart a homogeneous equivalent in the foreign
country,then by summing across the n goods a measure of the overall price level
in each country may be obtained as:
P t =
n∑
i=1
α i P i
t ,(2.2)