This document is a 3,524 word essay analyzing the concept of purchasing power parity (PPP). It begins by discussing the "Law of One Price" and how real-world deviations occur. It then introduces PPP and discusses attempts to test it, noting mixed results. Factors like non-tradable goods, the Balassa-Samuelson effect, and currency selection can distort PPP. While theory suggests PPP should hold, in practice it remains difficult to conclusively test due to the many variables that influence exchange rates. PPP remains a fundamental concept, but like the Higgs boson, its existence is not definitively proven.

1. Monetary Economics CA:
Purchasing Power Parity
2015
Name: Sam Deegan
Student Number: 20041091
Lecturer: Dr Cormac O’Keeffe
Class: Monetary Economics
Course: MBS – Economics & Finance
Date: 24/04/2015
WATERFORD INSTITUTE OF TECHNOLOGY| Cork Rd, Waterford, Co. Waterford

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1
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Sam Deegan Signed: ____________________________________
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Word Count: 3524

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“Enlightening in theory, confusing in practice”. Is this a fair verdict on the
concept of purchasing power parity (PPP)? Is market efficiency testable?
Discuss
Purchasing Power Parity (PPP) is one of the central theories in Economics. It states that
a bundle of goods in one currency should cost the same as in another currency once exchange
rates are considered. As such, PPP is a derivation of the “Law of One Price” (LOOP). The Law
of One Price asserts that in competitive markets, free from transportation costs and official
barriers to trade, identical goods in different countries must be sold at an identical price. As a
result, in order to assess why PPP both simultaneously clarifies and muddies our understanding
of exchange rate movements, we must begin by critically assessing why the LOOP as a theory
should affect pricing and how deviations form it occur. This will permit us to fully introduce
PPP and how it builds upon the LOOP and where previous studies have attempted to investigate
the impact of PPP. Finally we shall discuss what we can gleam from the aggregated
information, and whether it may be comprehensively tested.
According to Cassel, (1918) the LOOP should hold in a competitive market as price
deviations should be quickly eradicated by market forces, as they present a clear arbitrage
opportunity. However, in reality we know that markets totally free from barriers and transport
costs are non-existant. Cassel, (1918) recognised this, highlighting that in some cases where
trade is hampered in one direction, such as was the case with Sweden in WWI that deviations
would occur. Engel, (1999) developed this further and identified other factors which would
result in deviations, such as how sensitive consumers are to prices, and to what degree does
competitiveness and the impact of product differentiation hold upon industry prices. Engel,
(1999) also highlighted other factors at play such as what determined export prices to different
regions within an economy, and the price relationships that exists between the good at import
and the good at sale. Perhaps most insightfully Sarno, et al, (2004) stated that deviations from
the LOOP existed due to the the slow speed of price adjustments or hysteresis. This price
“stickiness” is due to the slow response of businesses to price fluctuations, due the paper costs
associated with adjusting to constantly fluctuating prices and the impracticalities that would
arise. Crucini & Shintani, (2008) concurred with this adding that level of hysteresis varies
significantly from good to good. However, even when significant price deviations do manifest

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themeselves Lamont & Thaler, (2003) point out that arbitrage opportunities are not risk free,
this due to the presence of noise traders, who can infact exacerbate the mispricing. In essence
academic research seem to suggest that the LOOP is far less strict in reality and seems to act
more like a LOOP with acceptable levels of deviation. However literature still supports the
premise that prices should be similar in the vast majority of cases in a barrier free market.
In the Introduction we defined PPP in its Absolute form, which posits that the exchange
rates between two currencies should reflect the ability of the respective currencies to purchase
the same basket of goods in their home market. It was in response to this relationship that
exchange rates were expected to adhere to in March 1973 when the major currencies moved to
a free floating mechnism (Frenkel, 1976; Taylor, 1995). This is expressed by the following
mathematical formula:
𝑆 = 𝑃 ÷ 𝑃∗
S = Spot Price
P = Price index of currency 1
P* = Price Index of currency 2
However, this relationship can only hold true under three conditions. The first, is that the goods
must be freely tradable with no barriers to trade. Secondly the price index of each country must
comprise of the exact same goods, given the same weighting and finally the prices must be
indexed to the same year. These three conditions however are incredibly hard to achieve, as a
result it is typical that studies aim to test Relative PPP (Taylor & Taylor, 2004). Relative PPP
suggest that percentage changes in exchange rates offset the differing inflation rates between
countries. This relationship is typically expressed:
𝑆1
𝑆0
= (1 + 𝐼 𝑦) ÷ (1 + 𝐼𝑥)
𝑆0 = Spot Price at the beginning of the period (using country “y” price of purchasing “x”)
𝑆1 = Spot Price at the end of the period
𝐼 𝑦 = Expected annual inflation rate for the foreign country (y)

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𝐼𝑥 = Expected annual inflation rate for domestic country (x)
Despite the fact that if Absolute PPP holds then Relative PPP must also hold the relationship
does not necessarily hold vice versa (Taylor & Taylor, 2004). Therefore we have little support
for Absolute PPP, while there are a significant a number of papers looking at Relative PPP.
What is clear from these papers is that Relative PPP does not seem to hold in the short
run (Taylor & Taylor, 2004), aside from a curious study on the use of the dollar on the Latin
American black market by Diamandis, (2003). According to Hau, (2000) we see typically
significant short-run deviations, due to the inclusion of non-tradables, which generate some
differential real returns, a fact which Engel, (1999) had also noted previously. What we find
however in many studies is that these effects seem to disapate in the long run. In fact, Jenkins
& Snaith, (2005) stated that they found little or no evidence of PPP, yet that support for PPP
grew as they moved from monthly to quarterly and annual data. This perhaps indicating some
sort of J-curve effect (Bahmani-Oskooee & Zhang, 2008), which would loosely fit with
Rogoff’s, (1996) suggestion that exchange rates had a half-life of three-five years due to a
number of factors including, but not limited to the lack of labour mobility and tariffs, along
with high transportation and information costs. As a result, Jenkins and Snaith, (2005)
concluded that the failure of PPP was due to the presence of non-tradables, that by excluding
non-tradables and moving to longer term data found some support of PPP. Others such as
O'Connell, (1996) believe that long term evidence from studies such as those conducted by
Kugler & Lenz, (1993) is founded upon sample selection bias. He posits that evidence for PPP
was stronger in the 1960’s, due to the fact that exchange rates were fixed, and that exchange
rates have undergone a structural change since the major currencies were allowed to float
freely.
One of the most prominent theories that has arisen in relation to PPP is the Balassa-
Samuelson effect, which suggests that a production bias manifests itself in PPP. Balassa, (1964)
states, that the ultimate source of income differential is productivity, and that this higher
productivity, drives higher wages. Balassa, (1964) believes that this is why we see trade
surpluses in developing countries as productivity expands much faster than wages and that

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therefore the demand for imported goods lag behind productivity increases. However, some
sectors in an economy, particularly in the service industry (which is larger in developed
economies (Kravis & Lipsey, 1998)) have fixed productivity and are non transportable, the
classical example of this type of good is a haircut. While a hairdresser in Ireland may be no
more productive than that in China, the hairdresser in Ireland will be paid more in order to
maintain a standard of living, therefore the cost of the haircut will also be higher, driven by the
labour cost (Kravis & Lipsey, 1998). As a result, non-tradeable goods do not conform to the
LOOP due to the immobility of labour resulting from barriers and transportation costs.
Research carried out by Rogers & Jenkins, (1994); Liu & Barrett, (1995) concurred with the
conclusions of the Balassa-Samuelson theory, and that the presence of non-tradable goods in
the Consumer Price Index (CPI) reduced the power of PPP. However, while Rogers & Jenkins,
(1994) believed that the Balassa-Samuelson effect plays an important role in the distortion of
PPP, they also believed that hysteresis along with the transportation costs of goods played a
much larger role as was suggested by Engel, (1999).
While the Balassa-Samuelson effect constitutes a perfectly reasonable assumption and
has received significant support in literature, studies for the Balassa-Samuelson effect have
thus far provided rather mixed results. Studies by both Holmes, (2001) and Faria & Leon-
Ledesma, (2003) for example could not find any supportive evidence of the effect, while
Lothian & Taylor, (2008) found evidence in the United Kingdom (UK£)/United States (US$)
exchange rate, yet not in the French (Franc)/ UK (£) rates1. It is at this point, once we consider
our currency selection in the search for PPP that our mental faculties are truly tested. In studies
conducted by Kugler & Lenz, (1993). Koedijk, et al., (1998) and Alba & Papell, (2007) we
found that PPP held between certain currencies but not with others. Kugler & Lenz, (1993)
found evidence of long run PPP in the many of the peripheral European economies which are
shown in a table on the next page. In fact, many of those European countries who did not
conform to PPP in the study had been countries involved in the European Exchange Rate
Mechanism (ERM) prior to 19862. This had fixed their exchange rates to the German
Deutschmark, which means that prices were sticky and very slow to converge in the absence
of a free floating exchange rate (Balassa, 1964).
1 Cuddington & Liang, (2000) found that PPP held for the franc-sterling, but not for the dollar sterling
2 Except for Italy

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Results from Kugler & Lenz, (1993)Multivariate Co-integration Analysis and the Long-Run Validity of
PPP
Currencies Which Conformed
to PPP
Currencies Which did not
Conform to PPP
Currencies with mixed Results
Pound Sterling
Norwegian Krone
Italian Lira
Portuguese Escudo
Spanish Peseta
US Dollar
Canadian Dollar
Belgian Franc
Danish Krone
Swiss Franc
French Franc
Japanese Yen
Dutch Guilder
Swedish Krone
However, the effect of currencies on PPP is not just limited to which we are comparing,
but the numeraire currency. Koedijk, et al., (1998) highlighted that the results of PPP studies
improved when denominated in the Deustchmark, Koedijk believed that this most likely due
to the currencies low volitility along with the countries proximity to other European countries.
Koedijk, et al., (1998) stated that results were weaker in the US Dollar, while the Japanese Yen
returned the weakest results, but why is this? If markets were truly efficient would it not matter,
Parsley & Wei, (2007) and Drine & Rault, (2007) point out that other factors such as the
movement of capital currency pegs, volitility and public spending can shift exchange rate
equilibrium levels, in fact Samuelson, (1964) and Kugler & Lenz, (1993) suggested that the
failure of PPP may be due to an overvaluation of the US Dollar.
This does not however answer why PPP does not seem relevant in Africa, Asia, Latin
America and CEE nation (Alba & Papell, 2007). Basher & Mohsin, (2004) point out that the
violations in PPP are pervasive in the Asian exchange rates, though exchange rate deviations
could be due to credit risk (Skinner & Mason, 2011). As such, the issue with PPP is that we
expect to see stronger evidence of PPP if it exists, especially amongst highly developed
economies with similar productivity levels and low inflation (Alba & Papell, 2007; Balassa,
1964). Whilst some evidence has been found amongst OECD countries in studies conducted
by Drine & Rault, (2007) and Kalyoncu & Kalyoncu, (2008) there is a lack of definitive
evidence and reports often contradict, for example Wu & Lin (2010) found that PPP held

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prior to the introduction but not after3. What does seem promising however is Alba & Papell’s
(2007) suggestion that PPP seems to hold in panels. This would make PPP significantly more
testable, not just because CPI’s would be far more similar, but also productivity levels and
close relations means that there are likely to be fewer barriers, such as the case with the EU
and NAFTA.
There is in fact one way in which we may test for PPP and that is by using a higly
standardised product that is universally available. The Economist magazine does this every
year using the McDonalds Big Mac as a barometer. As a barometer it makes a lot of sense as
it allows us to factor in the Balassa-Samuelson effect through the highly standardised method
of production. Parsley & Wei, (2007) found that the Big Mac Index is typically highly
correlated with the CPI index for most countries and we also know that the service element of
production accounts for 55%-64% of the pricing. We also observe that the tradable element of
the product undergoes far quicker price convergence than the non-tradable aspect. In practice
we find that the Big Mac Index is a biased method of predicticting currency values, though
once adjusted it tracks exchange rates reasonably well over the medium to long term in
ccordance with Relative PPP.
Overall it is clear to see that PPP is ingrained in the mind of academics as the reasoning
behind the idea is sound. As a theory its fits neatly into our current understanding and provides
us with significant insights into how the world economy will develop. This is not to say that
we are certain of PPP’s existence, nor is that to say it has been disproved. What we do
understand however is there are several other factors which drive exchange rates, and not PPP
alone. It is the sheer number of factors at play in this mechanism such as the Balassa-Samuelson
effect that makes PPP, which is such a simple and pure expression of market forces effects on
exchange rates so confusing in practice. As such PPP is possibly most comparable to the Higgs
Boson particle in Physics as all of our intuition as Economists tells us it exists in some form
and the role it form the very basis of our discipline, yet unlike the Higgs Boson Particle we
have not discerned a method by which we can conclusively say it exists or whether we have to
re-examine the fundamentals on which modern economics is built. As for the concepts market
3 Must bear in mind price stickiness and shifting EU composition

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testability there would be a number of conditions required in order to disregard other influences
on the data. As previously stated, we would need a significant amount of long run data in
relation to two countries with low inflation rates and similar levels of productivity. These
countries must also be in close proximity with few barriers to trade and free-floating exchange
rates with no significant asymmetrical shocks over the data period. Clearly due to the number
of variables in a model such as this a real world example would be incredibly hard to acquire
and even harder to replicate.

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