THE PURCHASING POWER PARITY MODEL: COMPARING MacDONALD WITH ZHOU AND MAHDAVI
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 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 pa...