Working Paper: NBER ID: w0865
Authors: Craig S. Hakkio
Abstract: This paper presents a systematic analysis of the purchasing power parity hypothesis (PPP). This hypothesis states that the exchange rate is equal to the ratio of the domestic price level to the foreign price level. It has recently been argued that PPP performs poorly in the 1970s. This paper examines several possible explanations for this poor performance . We examine PPF in the 1920s and the 1970s, using monthly and quarterly data, to see if the relationship has changed over time. We also examine PPP in a multi-exchange rate world, allowing a quite general error process so as to allow deviations from PPP to be autocorrelated and correlated across currencies. We are then able to examine the degree to which the world has become more interdependent. We also provide evidence that deviations from PPP may follow a random walk. Finally, the role of the U.S. dollar as base currency is examined. We find, in general, that PPP holds quite well as a long run proposition, but the deviations from PPP tend to persist.
Keywords: Purchasing Power Parity; Exchange Rates; Monetary Models
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| PPP holds as a long-run proposition (H44) | Deviations from PPP are persistent (F31) |
| Exchange rates and prices (F31) | Imprecision in relationship (C60) |
| Increased capital mobility (F20) | Deviations from PPP following a random walk (F31) |
| Deviations from PPP following a random walk (F31) | Shocks in one currency affect others due to interdependence (F31) |