The empirical evidence

Whether or not PPP holds is an ongoing controversy.The reasons why it might not hold are numerous.The strictest form of PPP requires that:

1.financial markets are perfect with no controls, taxes, transaction costs, etc;

2.goods markets are perfect with international shipment of goods able to take place freely, instantaneously and without cost;

3.there is a single consumption good common to everyone;

4.the same commodities appear in the same proportions in each country’s consumption basket.

These assumptions are clearly unrealistic.Goods and financial markets are not perfect.Goods cannot be shipped instantaneously; transport costs are high and import restrictions of various forms are widespread.Taxes, transaction costs and controls are present in the financial markets.There are also many types of consumption goods, and economic agents throughout the world have different tastes and preferences so that a common basket of consumption goods does not exist.Furthermore, the PPP hypothesis designates relative inflation differentials as the only source of exchange rate variations.At least in the short run, other non-monetary phenomena such as changes in relative prices as well as changes in the level and composition of output and consumption influence the supply of and demand for foreign currency and thus the exchange rate.With all these qualifications, the question is, then, to what extent purchasing power parity exists as a real world phenomenon.

Some studies find little support for the PPP hypothesis.Studies by J.D.Richardson, P.Isard, and I.B.Kravis and R.E.Lipsey find substantial deviations from the law of one price in the commodities markets.If the law of one price does not hold, then PPP is not likely to hold either.However, another series of studies finds that PPP does hold but with a considerable time lag.H.J.Galliot rested PPP between the United States and Canada, Great Britain, France, West Germany, Italy, Japan, and Switzerland from 1900 to 1967.H.J.Edison tested the dollar/pound exchange rate between 1890 and 1978.Both authors found that PPP is often violated in the short run but holds up will in the long run.

Traditional regression techniques have been replaced by the now well known cointegration technique, which states that if PPP holds as l long-term equilibrium, the exchange rate and the price level should be co-integrated.Abuaf and Jorion, analyzing annual data over the period 1900-1972 found that it takes about three years for deviations from PPP, although substantial in the short term, to be reduced by half.Most of the testing carried out since the inception of floating exchange rates at the beginning of the 1970s either rejects or provides only weak support for PPP, while tests done on longer periods or on high inflation economies provide stronger support for PPP.Despite disagreements over some specific points, the consensus emerging from the vast literature on the subject is that PPP in its relative form is generally valid, at least in the long run.

The evidence is also growing that PPP is more than a long-run phenomenon.R.J.Rogalski and J.D.Vinso, studying a period of floating exchange rates in the early 1920s and mid-1950s, found that freely floating markets react immediately or almost immediately to changes in relative inflation rates, and noted that their finding is consistent with both PPP and the efficient markets theory.The efficient market hypothesis holds that all relevant information is fully and immediately reflected in a security’s market price.R.Roll has applied the efficient markets hypothesis to PPP by assuming that the current spot rate reflects anticipated exchange-adjusted inflation differentials rather than a slow adjustment to past inflation differentials.His results on 252 pairs of countries over the period 1957 through 1976 strongly support this hypothesis and suggest that for most countries, and for all the largest trading nations, the adjustment duration is less than one month.