TESTING THE PURCHASING POWER PARITY HYPOTHESIS

This study tested the purchasing power parity (PPP) hypothesis in relation to consumer prices in four European Community (EC) member states. A background discussion on the PPP model follows this introduction. An explanation of the method used in this research follows the background discussion, a presentation of the data follows the explanation of the method, and the results of the research performed follow the presentation of the data.

The underlying basis of the PPP model a contention that relative rates of inflation determine long-range exchange rate changes. The assumption is that exchange rates adjust in a way that insures that, subsequent to conversion into another currency, a currency in question will purchase goods and services in a foreign country equivalent to that which it could purchase in the domestic economy.

The PPP model also assumes that exchange rates will fluctuate with respect to relative rates of price inflation between countries. It further assumes that shifts in trading patterns will cause changes in the relative rates of inflation between countries that will in turn maintain a long-term equilibrium in currency values.

One of the problems associated with use of the PPP model is the technical difficulty involved in deriving acceptable estimates of equilibrium exchang

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d Lai (1993), Kugler and Lenz (1993), MacDonald (1993), and MacDonald and Marsh (1994a) contend that the Johansen cointegration method to test for the number of cointegrating vectors among relative prices and exchange rates solves this problem. 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 literature contains mixed results relative to the testing of the validity of the PPP hypothesis. Few studies have found evidence for the theory in the short run, while the results of tests of the PPP hypothesis based on long-run data produced mixed outcomes. Hakkio [1984] found evidence to support PPP in the long-run analyzing date from the 1970s, as d
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Approximate Word count = 2127
Approximate Pages = 9 (250 words per page)

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