THE PURCHASING POWER PARITY MODEL

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.

The theory of purchasing power parity is relatively simple, and posits that applying the law of one price to a comparable market basket of goods and services across countries defines exchange rates between the countries. In its simplest form, it states that in the absence of government intervention and significant freight charges and tariffs, an internationally traded basket of similar goods should sell for the same effective price when converted into the same currency. Although simple in theory, real world complications such as differentiated products, tastes, and costly information can confound the testing of the PPP hypothesis.

The underlying basis of the PPP model is a contention that relative rates

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Approximate Word count = 1071
Approximate Pages = 4 (250 words per page)

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