This research compares the actual currency exchange rates for the French Franc and the German Deutschmark for the period 1975-1994 with the currency exchange rates projected by the Purchasing Power Parity (PPP) Model. Currency exchange rates were structured as French Francs per German Deutschmark. Data were calculated quarterly.
The PPP Model is based on a contention that relative rates of inflation determine long-range exchange rate changes (Hooper & Morton, 1982, pp. 39-42). In this model, it is assumed that exchange rates adjust in a way which 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 (Burtle, 1995, p. 130).
This model also assumes that exchange rates will fluctuate with respect to relative rates of price inflation between countries (Humpage & Karamouzis, 1986, p. 2). It further assumes that shifts in trading patterns will cause changes in the relative rates of inflation between countries, which will, in turn, maintain a long-term equilibrium in currency values.
The PPP Model has a strong theoretical appeal. The major problem with it is that is simply has been unable to adequately explain currency exchange rate changes over the long-term, and in a wide variety of environments (Hooper & Morton, 1982, pp. 52-54). The PPP Model, however, has been used successfully in more limited applications (Koveos & Seifert, 1985, p. 45).
One of the problems associated with use of the PPP Model is the technical difficulty involved in deriving acceptable estimates of equilibrium exchange rates (Humpage & Karamouzis, 1986, p. 2). Without such estimates, meaningful assessments of exchange rate level may not be made. 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,...