Does the purchasing power parity theory still hold ? The UK as the case study

Ashraf, Kamran and Masih, Mansur (2017): Does the purchasing power parity theory still hold ? The UK as the case study.

Abstract

The purchasing power parity (PPP) theory is an integral part of international finance. The PPP examines the relationship between the inflation rate differential between two countries and their exchange rate movements. The purpose of this study is to investigate whether the PPP still holds or not. The UK is taken as a case study. The standard time series techniques are employed to address the issue. Our findings tend to indicate that the PPP theory does hold in the long run as evidenced in the cointegration (or comovement) of the exchange rate and price ratio variable. Furthermore, the Granger-causality analysis unveils that an exogenous shock to the US-UK exchange rate disturbs the long run equilibrium and the domestic-foreign price ratio variable bears the brunt of short-run adjustment to bring about the long run PPP equilibrium. The exchange rate is found to be the exogenous leading variable and the price ratio variable is found to play the role of a follower in terms of endogenous adjustment. The findings have strong policy implications for international trade and investment.

• Item Type: MPRA Paper
• Language: English
• Keywords: exchange rate, domestic price, foreign price, cointegration, VECM, VDC
• Subjects: C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C22 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes; C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics; G - Financial Economics > G1 - General Financial Markets > G15 - International Financial Markets

References

Abauf, N. and Jorion, P. (1990), Purchasing power parity in the long run, Journal of Finance, 45, 157–174

Corbae, D. and Ouliaris, S. (1988), Cointegration and tests of purchasing power parity, Review of Economics and Statistics, 70, 508–511

Engle, R. F. and Granger, C. W. J. (1987), Cointegration and error correction: representation, estimation, and testing, Econometrica, 55, 251–276

Flynn, N. A. and Boucher, J. L. (1993), Tests of long-run purchasing power parity using alternative methodologies, Journal of Macroeconomics, 15, 109–122

Frenkel, J. A. (1981), The collapse of purchasing power parities during the 1970s?, European Economic Review, 16, 145–165

Johansen, S. and Juselius, K. (1992), Structural tests in a multivariate cointegration analysis of the PPP and UIP for UK, Journal of Econometrics, 53, 211–244

Layton, A. and Stark, J. P. (1990), Cointegration as an empirical test of purchasing power parity, Journal of Macroeconomics, 12, 125–136

Serletis, A. (1994), Maximum likelihood cointegration tests of purchasing power parity: evidence from seventeen OECD countries, Weltwirtschaftliches Archiv, 130, 476– 493

Taylor, M. P. (1988), An empirical examination of purchasing power parity using cointegration techniques, Applied Economics, 20, 1369–1381