The Purchasing Power Parity (PPP) theory states to exchange rates between currencies are in balance when their purchasing supremacy is the similar in each of the two countries. The relative external price of two currencies is strong-minded by their relative internal purchasing power. In particular, the PPP theory predicts to exchange rate change will be comparative to relative inflation. The utilize of inflation differential in calculating exchange rate changes for maintaining PPP was endorsed by Swedish economist Gustav Cassel during World War I. Interest in PPP has significantly improved after the breakdown of the set exchange charge regime in the early on 1970s when countries were switching from fixed to floating rate of currencies.
The ‘absolute’ version of PPP which is based on top of the ‘Law of One Price’ maintains that commodity arbitrage should equilibrate prices of the similar good at different location if they are converted to the same currency. However, transportation costs and other obstructions to the free flow of international trade inhibit cross country price equalization. Even with such obstacles the ‘relative’ version of PPP, which maintains that the change in the exchange rate more a period of time should be proportional to the comparative change in the value levels in the two countries, might still hold if relative price changes across countries are alike. In case of monetary shocks, in name only price of goods and services are likely to be changed by the same amount. As a result, relative prices amid diverse assets will stay constant. Thus, it is the ‘relative’ rather than ‘absolute’ PPP that is favorable to empirical testing.
The resurgence of importance in the PPP theory led to numerous empirical study to check the validity of the theory. Frenkel (1978) provided empirical evidence on the long-run validity of the PPP theory during the high-inflation years of the 1920s for the European and United States (US) economies. The results support the predictions of the PPP hypothesis that the nominal exchange rate is likely to be equal to the ratio of the price levels in two countries. On the contrary, Frenkel (1980) found that the PPP theory collapsed during the 1970s due to changes in commercial policies and non-tariff barriers to trade which were more stable within Europe than between Europe and United States. However, these studies did not check the stationarity properties of the variables. The regressions may be ‘spurious’ in the presence of nonstationary variables. In such a case, it is possible to study their behaviour only for the time period under consideration without generalizing it to other time periods. The cointegration theory provides an ideal structure for testing long-run equilibrium relationship implied by economic theory. Lastly, short-run dynamic error correction model (ECM) is estimated once equilibrium relationship among the variables is determined.
