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International Finance
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The theory of ‘purchasing power parity’ (PPP) explains that the nominal exchange rate existing

between two different currencies should be equal to the “ratio of aggregate price levels between

the two countries” (A. Taylor and M. Taylor, 2004, p. 1). In this case, one unit of currency in one

country would have identical purchasing power in the other country. If there is inflation in one

country, the exchange rate in the country facing inflation would be depreciated proportionally so

as to preserve parity in purchasing power in both countries. From another angle, PPP can be

defined as the “relationship between currency exchange rate and price levels in two countries”

(Ignatiuk, 2009, p. 5). Price level in home country is negatively related to the exchange rate

existing between two currencies and in the foreign country, price level is positively related to

exchange rate. When the ratio of the worth of “a fixed basket of goods” (Ignatiuk, 2009, p. 5)

between the two countries becomes equal to the ratio of exchange rates existing between both

countries, equilibrium is attained. At this point parity is maintained between the purchasing

powers in the two countries.

In other words, ‘the Law of One Price (LoOP)’ is the foundation theory of PPP. In this theory, in

order to suppose that two goods are sold at equal prices in two countries; transportation costs,

taxes, tariffs and other barriers to international trade are not considered. The Law takes into

consideration the assumption of competitive market and identical goods. The statement of the

Law can be summarized as: when prices are expressed in the currency of one country, the prices

of two identical commodities traded in competitive markets in the two countries, which are

engaged in trade with each other, would be the same (Ignatiuk, 2009). Impediments to

international trade can bring violations to the Law of One Price. Alternatively, differences in

pattern of taste and preferences of the people of different countries can also violate the

purchasing power parity.

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The theory of arbitrage in the international market serves as the fundamental rationale for PPP

theory.

Absolute and Relative PPP

The interpretation of the Law of One Price forms the basic ground work for absolute PPP. In this

interpretation, the absolute level of price in the two countries is related to the level of exchange

rate existing between the two countries.

If the domestic price of a commodity basket is represented by Pt at home and by Pt* in foreign

and ‘e’ is the nominal exchange rate, absolute PPP is valid when the following relation holds:

e = Pt/Pt*

Under a fixed exchange rate, the traditional notion of LoOP says that price level in home would

be determined by exchange rate (Krueger, 1983).

Absolute PPP says that exchange rate should adjust in such a way that at spot exchange rate the

price level of foreign is same as the price level of domestic. This ensures equality between home

and foreign price levels (Machiraju, 2007). Thus, absolute PPP concentrates on the role played

by international trade in the determination of exchange rate. If Pt/Pt* = 1 then, there is

purchasing power parity. From this one can deduce, either exchange rate determines prices or

prices are determined by exchange rate. Relative PPP, on the other hand, deals with percentage

change in home and foreign prices, rather than their absolute levels. Emphasis is on the ‘change’

in prices of commodity baskets and hence can be applied in places in which consumption baskets

are different (Machiraju, 2007).

PPP and International arbitrage activity

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The equality between the ratio of currencies in two countries and the ratio of price levels in both

countries is assured by arbitrage equilibrium (Cheung and Lai, 1994). Considering the central

essence of the PPP theorem, one can state the PPP as “an arbitrage condition” (Krueger, 1983, p.

24). PPP can come into effect if costless arbitrage holds. This proposition is applicable only in

case of tradable goods and under assumption of no transport cost. If, after adjustment of

exchange rates between two trading countries, their price levels are not equal, arbitrage would

take place. This would ensure that the goods are available worldwide. It implies that prices of

goods in the two countries would be revised according to the levels of availability of those goods

in those countries and price levels would move towards equality. Thus, purchasing power parity

is a condition that emerges out of arbitrage activities.

Empirical support

Empirical support is not widely available in support of the PPP theory. Exchange rates are often

found to deviate from PPP. The point of conflict between exchange rate and PPP is that whilst

exchange rates frequently deviate from existing PPP, price levels are adjusted slowly over a

longer period of time. If one considers PPP to be the representative of the real world trade

scenario, one should expect to find empirical evidence in the form of similar pattern of changes

between exchange rate and prices, which does not hold. In this context it can be concluded that

relative inflation rate prevailing in the home country and the foreign country do not influence

exchange rate changes (Machiraju, 2007). In short run, one cannot find much variability in rates

of inflation, which indicates that exchange rate changes are affected in short run by causes other

than prices of commodities.

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Thus, it can be inferred that price level of a country is not determined by the exchange rate;

neither can it influence the exchange rate in the short run. In the long run, however, there are

evidences that suggest that exchange rate gradually converges to PPP. PPP seems to hold in the

long run under stationary real exchange rate (Habermeier and Mesquita, 1999). Real exchange

rate reflects mean reversion tendencies in the long run. Frankel and Rose have shown that

deviations from PPP tend to get eroded in long run (Frankel and Rose, 1996). The price index

composed with traded goods (TPI) is a good index to conduct PPP tests and depicts a half life of

approximately one year for the erosion of estimated deviation from PPP (Xu, 2003). However,

Engel (2000) strongly argues that, significant biases are involved in the tests for long run PPP.

Use of disaggregated data related to prices and data standardized to nominal exchange rates are

the root causes behind such biases.

Parity conditions set by PPP are visibly intuitive and simple. The concept of PPP is based only

on the number of goods that are traded among trading countries. However, a proportion of the

domestic product is also represented by non-tradable goods that are not accounted for in the

GDP. In less developed countries, the proportion of such goods is significant (Machiraju, 2007).

Thus, if the purchasing power of the people in advanced countries and less developed countries

is measured by PPP, it would undervalue the actual purchasing power of the consumers of poor

countries. According to Balassa and Samuelson (1964 cited in Spanjers, 2009), the overall price

index in the developed countries is higher than that in the less developed countries due to the

difference in productivity of labour in the two countries. Therefore, one US dollar can buy more

goods in a poor country than its richer trading partner. Apart from non traded goods, deviation

from the LoOP can also occur in case of traded goods. In short run, empirical evidence presented
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in works by Engel (1993 cited in Froot and Rogoff, 1995) suggest strongly that these deviations

are closely associated with movements in nominal exchange rate.

Theoretical as well as empirical evidence show that in short run, PPP condition may be invalid

due to various reasons (Calderon and Duncan, 2003). The most obvious reasons are existence of

transaction costs and frictions in trade, differences in the basket of goods that are used in

constructing aggregate price index for different countries and government intervention in market

for foreign exchange. These reasons might play a dominant role in establishing non linear

relationship between price levels and exchange rates (Liew, Chia and Ling, 2009).

Conclusion

Lack of empirical evidence supporting PPP theorem indicates that the amount of attention

provided to this theory is excessive and unnecessary. In the short run, the PPP theorem is

invalidated, which provides scope for arbitrage by the traders of home and foreign countries.

While conducting this study it has been found that several studies have been conducted in the

past in which the PPP hypothesis has been put to test in varying geographical and economical

backgrounds. The results from those researches show mixed results. The PPP hypothesis test is

satisfied by some individual countries or groups of countries, while other countries do not satisfy

the test (Habermeier and Mesquita, 1999). The central point to be noted behind the non-

establishment of PPP for all countries uniformly is the diversity between the countries with

respect to their individual development level, average rate of inflation in the long run, openness

to international market and preferences of the consumers. Thus the basic concept of parity in

purchasing power and equalizing the commodity prices between the developed and the less

developed countries is questionable. Systematic deviation of real exchange rate from the PPP
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resulting from non-stationary real exchange rates trigger the question whether long run stable

relationships exist between real exchange rate and other variables. Study conducted by Engel

(2000) further suggests that PPP might not hold in its own right even in the long run. Yet,

empirical testing for the theory of PPP has been evolving constantly. New econometric

techniques are being adopted for testing the PPP hypothesis (Habermeier and Mesquita, 1999),

which would shed more light on this debate regarding purchasing power parity.
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References
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long span study for Chile. Estudios de Economía, 30(1), pp. 103-132.
Cheung, Y. and Lai, K. S., 1994. Mean reversion in real exchange rates. Economics Letters,
46(1994), pp. 251-256.
Engel, C., 2000. Long-run PPP may not hold after all. Journal of International Economics,
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Froot, K. A. and Rogoff, K., 1995. Perspectives on PPP and long run real exchange rates.
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