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Does the purchasing power parity theory hold for the exchange rate between the USA and Malaysia ?

Olujobi, Khalilat and Masih, Mansur (2018): Does the purchasing power parity theory hold for the exchange rate between the USA and Malaysia ?

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Abstract

One of the most controversial theories in international economics is Purchasing power parity (PPP) and has been debated in the literature for decades and there is still a controversy whether exchange rate between two currencies is determined by the change in relative prices of the two countries. Also in recent studies, the most used price indicator is consumer price index, which was argued that it might not capture the entire price, hence this paper attempts to use producer price index to test for PPP between Malaysia and the US. and applies a time-series technique like Long Run Structural Modeling (LRSM), to explore and aims to examine if purchasing power parity holds between Malaysia and USA by considering the nominal exchange rate between the two countries and their price level (with PPI used as the index) in order to see the long and short-term correlations among these variables. Empirical results tend to show that there exists a cointegration between Exchange rate, Malaysia price level and US price level. This indicates that there exists a long-term stable relationship between these variables. In addition, empirical results of the causal relation show that consistent with established purchasing power parity theory, none of the variables are causing or leading another (all endogenous), which indicates that the three variables are adjusting to bring about equilibrium in the long run, hence it is concluded that purchasing power parity holds between Malaysia and USA.

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