Part 3: Topic 1

In this part, we will find whether the Purchasing Power Parity is valid despite many theoretical
objections, such as tax, tariff, inflation or non-tradeable components cost like services, which
would result in a breach of the Law of One Price. Thus, empirical evidence would be examined.
In the “The Purchasing Power Parity Debate” in 2004, Taylor. M and Taylor. A plotted 2 panels
including the consumer price index (CPIs) from 1820 to 2001 and the producer price index (PPI)
from 1791 to 2001 for the US and UK. Both panels are described in USD terms using the
exchange rate at that point of time. The purpose is to determine if PPP is a reasonably acceptable
approximation to the real world in either its relative or its absolute forms.

Figure 1:
According to figure 1, absolute PPP did not hold consistently and exactly: in both instances,
there is some imperfection in the connection between the two lines. Which means there are
significant short-run PPP variances. Moreover, the national pricing levels of the two nations,
reflected in a single currency, did have a tendency to move in unison over these years. Finally, in
comparison to consumer prices, there is a significantly stronger link between the two national
price levels and producer prices (Taylor. M and Taylor. A, 2004). Besides, to examine the PPP in
the long run and short run, Taylor. M and Taylor. A plotted 4 graphs using data on CPIs of 20
industrialized countries and 26 developing countries and PPIs of 14 industrialized countries and
12 developing countries from 1970 to 1998 to find the inflation relative to the U.S. versus dollar
exchange rate depreciation of CPI and PPi annually and 29-year average. The 4 graphs are
shown below in figure 2.

Figure 2:
According to Figure 2, relative PPP seems to hold more tightly for nations with relatively high
inflation, but it does not appear to hold perfectly and consistently in the short term. Moreover, on
a long-term basis, relative PPP appears to hold. Besides, using PPIs rather than CPIs appears to
result in a stronger degree of association between relative inflation and exchange rate
devaluation over the longer-term means. Overall, the empirical research found that in the short
term, both absolute and relative PPP seem not to hold tightly, but both seem to hold rather well
over the long run and when there are significant changes in relative prices. Additionally, both
seem to hold better across PPIs than between CPIs. Despite using different methods to find the
validity of PPP in the real world, Sarno. L & Taylor. M (2002) and Sureyya (2021) both also
found that the exchange rate appears to hold in the long run since the more they are from
equilibrium, the more mean reverting they become. In my opinion, the PPP seems to hold in the
long run rather than the short run due to the sensitivity of exchange rate to people expectations in
the short run. According to Wright. R (2012), due to the short-term efficiency of foreign
exchange markets, market movements are just caused by expectations of changes in relative
inflation, exports, imports, trade barriers, and productivity. Therefore, owing to the great reliance
of exchange rates on market expectations and transactions, it is impossible to reach equilibrium
exchange rates, which results in an incorrect result for the value of the currency in the exchange
market. Besides, using PPIs is better than CPIs in forecasting the exchange rate since while the
CPI estimates price changes from the standpoint of household consumers, the PPI estimates price
movements from the perspective of domestic manufacturers. Imports are not included in the PPI
since it is designed to assess the productivity of domestic producers (Shah. S, 2021). Therefore,
mitigate the risk of breaching the Law of One Price by excluding the non-tradeable cost of tax
and tariff in imports.
References
Sarno, L., Taylor, M. (2002). Purchasing Power Parity and the Real Exchange Rate. IMF Econ
Rev 49, 65–105. https://doi.org/10.2307/3872492
Shah, S. (2021), “Consumer Price Index (CPI) vs. Producer Price Index (PPI): What’s the
Difference?”. Investopedia, viewed 16 August 2023, <
https://www.investopedia.com/ask/answers/011915/what-difference-between-consumer-price-
index-cpi-and-producer-price-index-ppi.asp>
Taylor, A. Taylor, M. (2004). The Purchasing Power Parity Debate. Journal of Economic
Perspectives Volume 18, Number 4 Fall 2004 Pages 135–158. DOI: 10.1257/0895330042632744
Sureyya. (2021). THE VALIDITY OF THE PURCHASING POWER PARITY HYPOTHESIS
IN OECD COUNTRIES: EVIDENCE FROM THE FOURIER TEST. International Journal of
Economics, Business and Politics 2021, 5 (2), 274-289. https://doi.org/10.29216/ueip.988853
Wright, R. (2012). Finance, Banking, and Money (v. 2.0).
https://2012books.lardbucket.org/books/finance-banking-and-money-v2.0/s21-04-short-run-
determinants-of-exch.html