PPP Theory

Introduction

As the number of international trading increases, exchange rate becomes one of the most important factors in the global commodity market and financial market since international trading depends mainly on the exchange rate. The exchange rate is the rate at which one currency is able to exchange for another currency of the same value (Dermot McAleese, 2004).

Exchange rate is the main determinant of the level of imports and exports of a country, if the local currency appreciates, it is less expensive to import and the goods imported become more attractive because of the lower price; however, local goods become relevantly more expensive and less attractive for other countries to import, therefore the level of export decreases. Exporting

However, this theory of PPP attracts the scholars till the XX century due to the contribution of a Swedish scholar Gustav Cassel in 1910s (Taylor, 2006). Cassel presented PPP theory using an equivalent term “theoretical rate of exchange” three years ago before he first defined the term PPP and place it into a systematic framework. Additionally, Cassel is also the first person who tested PPP empirically. The cumulative CPI inflation rates of different countries are suggested to be calculated and used to obtain the most effective exchange rate by Cassel to maintain the parity of purchasing power among different countries after the World War I. PPP generally explains a long run relationship between the price level and the exchange rates in the market; however, it is believed by money economists that PPP does not hold in the short

CPI represents the fluctuation of goods’ prices in a period and it contains a basket of different goods so can bring PPP to a more general situation. However, there are some problems associated with the absolute version of PPP. It needs to be considered that which CPI should be taken into account and how to deal with the fluctuation of CPI over time.

In order to overcome the problems associated with the absolute version of PPP, the relative PPP is introduced. It is similar to absolute PPP and connected the exchange rate, inflation rate and the interest rate, and it can be expressed as:

(∑▒P_it )/(∑▒P_(it-1) )=E_t/E_(t-1) (∑▒P_it^* )/(∑▒P_(it-1)^* )

This means that if the differential in the growth of good i’s prices in both countries and the rate of growth in exchange rate can be balanced over the estimation period, then PPP holds in the relative version. Therefore, it is apparently that relative PPP has improved a lot based on the original PPP theory and it is more appropriate for the empirical analysis of PPP.

Empirical Evidences of