odels have demonstrated staying power. These models are (1) the purchasing power parity (PPPM) model, (2) the current account balance (CABM) model, and (3) the portfolio balance (PFBM) model. Additionally, the random walk model (RWM), and the international Fischer effect model (IFEM) have gained some recent acceptance.
The basis of the PPPM is a contention that relative rates of inflation determine long-range exchange rate changes. In this model, 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 (Canner & Kilian, 2001).
This 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, which, in turn, will maintain a long-term equilibrium in currency values (McDonald, 1995).
The PPPM has a strong theoretical appeal. One of the problems associated with use of the PPPM is the technical difficulty involved in deriving acceptable estimates of equilibrium exchange rates. Without such estimates, meaningful assessments of exchange rate level are not possible. These difficulties stem from (1) the use of different measure in inflation in various countries, and (2) the selection of a base period for analysis. Lastly, the problems associated with the use of the PPPM involve the model's inability to account for factors other than inflation, which also affect currency exchange rates (Zhou & Mahdavi, 1996).
The condition of absolute PPP usually involves a two-country setting in which the two countries each produce a range of homogeneous traded goods wherein the concept of a single price holds for each of the goods. Thus, an increase in t...