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PURCHASING POWER PARITY MODEL (PPP).
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Discusses the validity of the PPP hypothesis.... More...
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Paper Abstract:
Discusses the validity of the PPP hypothesis. Theory of PPP. Underlying basis of the PPP model. Rates of inflation and long-range exchange rate changes. Assumptions of the PPP model. Problems associated with use of the model. Contends that long-run analyses tend to support the PPP hypothesis, but not short-run analyses.

Paper Introduction:
THE PURCHASING POWER PARITY MODEL: COMPARING MacDONALD WITH ZHOU AND MAHDAVI Introduction The literature contains mixed results relative to the testing of the validity of the purchasing power parity (PPP) hypothesis. Few studies have found evidence to support the theory in the short run, while the results of tests of the PPP hypothesis based on long-run data produced mixed outcomes, with a majority of the studies supporting the hypothesis for long-run projections. The studies with opposing results are the MacDonald (1995) study, which supports the PPP hypothesis for long-run projections, and the Zhou and Mahdavi (1996), which does not support the PPP hypothesis for long-term projections. This paper compares and discusses these two studies.

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This paper compares and discusses these two studies. If there is no long-run relationship between the exchange rate and relative prices, theresidual series also is non-stationary. the purchasing power parity Model: comparing macdonald with zhou and mahdavi Introduction The literature contains mixed results relative to the testing of thevalidity of the purchasing power parity (PPP) hypothesis. The restrictive character of the absolute PPP hypothesis issuch that even if it were possible to construct prices in the mannersuggested by the hypothesis, the existence of transportation costs andother impediments to trade would interfere with the functioning of thehypothesized process. The studies with opposing results are the MacDonald (1995)study, which supports the PPP hypothesis for long-run projections, and theZhou and Mahdavi (1996), which does not support the PPP hypothesis for long-term projections. Differentsets of data yield different results. Thus,an increase in the domestic price level in one of the two countries shouldresult in a proportionate depreciation of the exchange rate between the twocountries. The testresults did not support the uncovered interest rate parity or PPPconditions. An assumption that such factors remain constant overtime, however, permits the absolute purchasing power parity hypothesis towork. If the variables are all first-order, non-stationary in the test ofthe PPP hypothesis, the integration is an order of 1. The PPP model also assumes that exchange rates will fluctuate withrespect to relative rates of price inflation between countries. Conclusion The character of the research on the PPP is controversial. Zhou and Mahdavi (1996), in contrast to MacDonald (1995), found thatshocks to equilibrium values of the exchange rates that arise from changesin real factors cause deviations of the exchange rates from their PPPvalues and weaken their links with the real interest rate differentials.Zhou and Mahdavi used a model that linked the real exchange rate with realinterest rate and price level differentials as well as other variables,cointegrating relations among model variables and out-of-sample forecastsof exchange rates using error-correction models were tested. Without such estimates, meaningful assessmentsof exchange rate level are not possible. Tests of the PPP hypothesis requirethe selection of appropriate data sets for the determination of relativeprices. MacDonald (1995) argued that the balance of evidence is supportive ofthe existence of some form of long-run exchange rate relationship.MacDonald (1995) found further, however, that the relationship does notaccord exactly with a traditional representation of the long-run exchangerate. Long-run exchange rate modeling.International Monetary Fund Staff Papers, 42(3), 437-489. In the real world, such priceseries are not available. Simple vs. The PPP hypothesis states that the percentage exchange ratedepreciation is equal to the difference between domestic and foreigninflation. It furtherassumes that shifts in trading patterns will cause changes in the relativerates of inflation between countries that will in turn maintain a long-termequilibrium in currency values. Thus, consumer price indexes (CPIs) and producerprice indexes (PPIs) typically represent prices in the testing of the PPPhypothesis. While the PPP is far from perfect,it appears to be the best model in the tool box. The underlying basis of the PPP model is a contention that relativerates of inflation determine long-range exchange rate changes. These difficulties stem from (1)the use of different measures in inflation in various countries, and (2)the selection of a base period for analysis. One of the problems associated with use of the PPP model is thetechnical difficulty involved in deriving acceptable estimates ofequilibrium exchange rates. Theassumption is that exchange rates adjust in a way that insures that,subsequent to conversion into another currency, a currency in question willpurchase goods and services in a foreign country equivalent to that whichit could purchase in the domestic economy. Long-run analyses tend to support the PPP hypothesis; however, such isnot the case with short-run analyses. The condition of absolute PPP usually involves a two-country settingin which the two countries each produce a range of homogeneous traded goodswherein the concept of a single price holds for each of the goods. Few studies havefound evidence to support the theory in the short run, while the results oftests of the PPP hypothesis based on long-run data produced mixed outcomes,with a majority of the studies supporting the hypothesis for long-runprojections. The relative PPP hypothesis will still hold, however, if overallprices are homogeneous to a degree of one. Although simple intheory, real world complications such as differentiated products, tastes,and costly information can confound the testing of the PPP hypothesis. Lastly, the problemsassociated with the use of the PPP model involve the model's inability toaccount for factors other than inflation, which also affect currencyexchange rates. In its simplest form, it states that in the absence of governmentintervention and significant freight charges and tariffs, aninternationally traded basket of similar goods should sell for the sameeffective price when converted into the same currency. References MacDonald, R. This approach holds that anincrease in the money supply should leave equilibrium relative pricesunchanged and should increase all prices by the same amount. Some researchers contend that the failure to find a cointegratingrelationship between relative prices and an exchange rate likely is afunction of the econometric method used, as opposed to the actual absenceof a long-run relationship between the variables. Zhou, S., & Mahdavi, S. If there is a long-run relationship between an exchange rate andrelative prices, the appropriate method for the validation of therelationship is cointegration analysis. Comparison and Discussion The theory of purchasing power parity is relatively simple, and positsthat applying the law of one price to a comparable market basket of goodsand services across countries defines exchange rates between the countries. Cointegration exists when thereexists some linear combination that transforms the residuals to a I( )series. (1995, September). Ideally, a price series consisting of the prices of homogeneousinternationally traded goods is desirable. (1996, Summer). generalizedinterest rate and purchasing power parity models of exchange rates.Quarterly Review of Economics and Finance, 36(2), 197-218. As each of these measures typically include non-traded goods,however, the degree of symmetry and proportionality desired frequently arenot attained through the testing of the hypothesis. A restructuring of the hypothesis states that the change in thereal exchange rate, conditional on relative PPP holding, will result in thelogarithmic real exchange rate change equaling zero.

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