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As is well known, Purchasing Power Parity (PPP) theory states that exchange rates adjust over time so as to offset divergent movement in national price levels. This implies that a country that runs an inflation higher than its trading partner(s) will see its currency depreciating. Originally put forth by Cassel (1918), this theory was initially proved to be capable of explaining exchange rate movements. Officer (1976) provides a detailed description of the development of the PPP theory over the years and the empirical work undertaken to test the theory.
In general, there is a consensus that the PPP theory is valid when a sufficiently long time interval is considered. But at the same time, it is stressed that the concept is relevant only in the long-run, so that deviations from parity may be the rule in the short-run. While fundamental economic variables and behavior such as substitution in demand would ensure the "law of one price" in the long-run, at any given point in time, other factors such as speculative activity could cause such deviations from PPP. The presence of non-traded goods and services has also been pointed out as a cause of deviations from PPP. Efforts have also been made to establish that deviations from PPP form a random walk, with no tendency for reversion to parity.(1)
This paper is devoted to two tasks, both undertaken for the Canadian Dollar-US Dollar exchange rate, the Deutsche Mark (DM)-US Dollar Rate and the US Dollar-Pound rate, with quarterly data for the period from 1974-1988.
First, deviations from PPP in the short-run are modeled as forming a dynamic adjustment mechanism towards a long-run equilibrium where PPP holds. To do this, the error-correction approach popularized in the study of consumption behavior by Davidson, Hendry, Srba, and Yeo (1978) is adopted.(2) It is examined whether short-term PPP exists at all, and the long-run equilibrium solutions are discussed. Second, a possible cause for deviations from PPP in the short-run is put forward and examined for applicability to the exchange rates under consideration. The argument tested here is whether PPP holds with respect to expected rather than actual current prices, in which case short-run PPP, in the conventional sense, with respect to current prices, will not hold.(3)
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