Academic journal article Journal of International Business Research

An Empirical Test of Purchasing Power Parity: Does It Hold between U.S.A. and Emerging Asian Countries

Academic journal article Journal of International Business Research

An Empirical Test of Purchasing Power Parity: Does It Hold between U.S.A. and Emerging Asian Countries

Article excerpt

INTRODUCTION

There are two established theories of exchange rate determination. One is interest rate parity and the other is purchasing power parity (PPP). This paper deals with an empirical test of purchasing power parity. Purchasing power parity states that exchange rates of two currencies will adjust based upon the movement of the consumer price index of the two respective countries. This paper does an empirical test of purchasing power parity between the U.S.A. and some emerging Asian economies which includes India, Korea, Malaysia, Pakistan, Thailand, the Philippines and Singapore. The CPI for each country for the year 2000 was equal to 100 and the CPI for 2007 was chosen to determine if purchasing power parity holds or not. Usually a base year is chosen where the CPI=100 and a future year is chosen and the actual CPI for that year is used to forecast the exchange rate. If the forecasted exchange rate is equal to the actual exchange rate, then we will conclude that purchasing power parity holds between the two countries.

PURPOSE AND METHODOLOGY

There is an abundance of research on purchasing power parity, but very few deal with an empirical test. This study does an empirical test of PPP between the U.S.A. and emerging Asian economies. The countries included are India, Korea, Malaysia, Pakistan, Thailand, the Philippines and Singapore.

HYPOTHESES

H1 Null hypothesis: PPP holds between the U.S.A. and emerging Asian economies.

H2 Alternative hypothesis: PPP does not hold between the U.S.A. and emerging Asian economies. The CPI for 2000 = 100 and the CPI for 2007 was chosen to forecast the exchange rate based on PPP.

The difference of actual exchange rate and the projected exchange rate were taken and a t-test was done to test the hypothesis.

LITERATURE REVIEW

It is determined that non-stationary real exchange rate in the long run between nominal exchange rate and domestic and foreign prices is almost non-existent, and therefore it is concluded that the theory of Purchasing Power Parity is invalid (Su & Chang, 2011). Therefore, it is concluded that exchange rate cannot be predicted using PPP. PPP states that if the price of a basket of goods is the same in two countries then the exchange rate must be at equilibrium. Given any international goods market arbitrage is traded away, then we must expect exchange rate to be at equilibrium. Given any international goods market arbitrage is traded away, then we must expect exchange rate to be at equilibrium. It is true that empirical evidence on the stationarity of real exchange rates is present, but it remains inconclusive.

Numerous studies have found support for a unit root in real exchange rates but critics contended that such a conclusion is probably attributed to the lower power of the conventional unit root test employed. This is because a growing consensus that conventional unit root tests fail to incorporate structural breaks in the model (Lin & Chang, 2010). Lin and Chang employed a stationarity test with a fourier function which has been recently introduced by Beeker (Beeker, et al, 2006). In their study the empirical results of nine post communist economies in Europe, Lin and Chang concluded that PPP does not hold in those nine post-communist transition economies.

There is an abundance of empirical evidence on the stationarity of the real exchange rates; however, there are none conclusive. The reason for that may be explained as because most of the prior studies implicitly assumed that exchange rate behavior is inherently linear in nature. Taylor and Peel (Taylor & Peel, 2000) have proven that the adoption of linear stationarity test is inappropriate for the detection of mean reversion given that the true process of the data generation of the exchange rate is in fact a stationary non-linear process (Taylor & Peel, 2000).

Lee and Zhu used monthly data covering from 1997 to 2009 in order to apply stationary test with a fourier function which has been proposed by Enders and Lee (Enders & Lee, 2004, 2009) which tests the validity of PPP, covering seven major OPEC countries. …

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