The purchase power parity hold in the 21st century
Does the purchase power parity hold in the 21st century?
Exchange rate determination has always been an interesting yet controversial topic in macroeconomics. Developed by Gutav and Cassell in the early 20th century, the purchasing power parity (PPP) is one of the most influential models of exchange rate determination over the past century. While the PPP gives a theoretical consistent explanation of exchange rate determination, empirical studies of the 20th century tend to blatantly reject the theory of PPP (Meese and Rogoff, 1983; Froot and Rogoff, 1995; Pilbeam, 2006). Nevertheless, many economists still believe that the PPP is valid explanation of exchange rate determination, at least over the long run (Patel, 1990; Abuaf and Jorion, 1990; Cheung, 1993). The research question of this study is therefore defined as:
1. Is the absolute PPP valid in the 21st century?
2. Is the relative PPP valid in the 21st century?
3. What are the underlying factors that lead to the validity/invalidity of the PPP?
Theoretical Framework and Background Information
The theoretical rationality of the PPP is very straightforward. Based on the theory of the law of one price, the PPP suggests that in the absence of transaction costs and trade barriers, good arbitrage across countries would result in the equalisation of the prices of the same goods or the same bundle of goods across different countries (Balassa, 1964; Taylor, 2013). There are two versions of the PPP. The absolute PPP relies on a strict application of the law of one price, the absolute PPP suggests that the real exchange rate between two countries are equal to 1 because the same bundle of goods of the same characteristics should have the same price, regardless of their origin (Pilbeam, 2006; Samo and Taylor, 2002). Mathematically, this is stated as where p is the price of a bundle of domestic goods and is the price of a bundle of foreign goods (Pilbeam, 2006; Samo and Taylor, 2002).
In contrast, the relative PPP recognises there may be fictions such as trade barriers and transportation costs that cause the real exchange rate between two countries not being equal to 1 and thus the failure of the PPP (Samo and Taylor, 2002). Rather than relying on a strict interpretation of the PPP, the relative PPP suggests that the real exchange rate between two countries is a constant dictated by the real price differentials between two countries; that is: (Pilbeam, 2006).