Academic journal article South Asian Journal of Management

Purchasing Power Parity Hypothesis: Some Empirical Evidence from Sri Lanka

Academic journal article South Asian Journal of Management

Purchasing Power Parity Hypothesis: Some Empirical Evidence from Sri Lanka

Article excerpt

This paper examines the Purchasing Power Parity (PPP) hypothesis for Sri Lanka using six exchange rates during the recent float. Graphical as well as econometric analysis using new unit root tests overwhelmingly reject the PPP hypothesis for Sri Lanka while old unit root tests provide mixed evidence. These results have important implications for policy-makers, business firms and corporate foreign exchange dealers in Sri Lanka. The mixed results provided by the old unit root tests are attributed to their low power and their inability to account for unknown means and trends in real exchange rates. The nonlinear adjustment of the real exchange rates towards deviations from PPP may also be a reason for the failure of the PPP which should be confirmed by future research.


Purchasing Power Parity (PPP) is a cornerstone of many theoretical models in international finance. It asserts that the price of a particular commodity, when expressed in a common currency, should be the same in every country. The PPP is an important concept for policy-makers, business firms and corporate foreign exchange dealers. Policy-makers in developing countries are concerned with the PPP for at least two reasons (Holmes, 200Ib). First, PPP can be used as a model to predict exchange rates and determine whether a particular currency is over or undervalued. Predicting exchange rates and determining whether a currency is over or undervalued is particularly important for less developed countries and those experiencing large differences between domestic and foreign inflation rates. second, many theories of exchange rate determination use some notion of PPP in their construction. Therefore, the validity of PPP is important to policymakers in developing countries who make their recommendations on the basis of PPP (Liu and Burkett, 1995).

The business firms which are engaged in international trade are often concerned with economic exposure. The economic exposure resulting from deviations from PPP affects the market value of a firm. Therefore, managers can use the concept of PPP to recognize economic exposure and take actions necessary to maintain the market value of the firm. When it comes to corporate foreign exchange dealers, they normally use some trading rule to beat the market. One such trading rule uses the PPP to identify currencies that are undervalued and overvalued. Undervaluation and overvaluation of a currency are implied by the differences between the actual value of a currency and the value of that currency on the basis of PPP.

Empirical evidence on the PPP is abundant in relation to developed as well as developing economies (see, Moosa, 1994; Papell, 1997; Fritsche and Wallace, 1997; Kouretas, 1997; Heimonen, 1999; Gil-Alanla, 2000; Caporale et al?, 2001; Esaka, 2002, for developed countries and Soofi, 1998; Choudhry, 1999; Azali et al., 2001; Nagayasu, 2002; Holmes, 2002; Achy, 2003, for developing countries). These studies use different data sets and methodologies. However, the results of empirical studies, particularly during floating exchange rate regimes, have not been consistent and provided mixed evidence on the validity of PPP.

Almost all empirical studies on the PPP prior to the early 1990s were conducted on the assumption of linear adjustment of real exchange rates towards deviations from PPR However, several recent papers (see, Dumas, 1992; Uppal, 1993; Sercu et al., 1995; Coleman, 1995) have developed models of real exchange rate determination which take into account frictions existing in international trade such as transaction costs. These frictions lead to nonlinear adjustment of real exchange rates toward deviations from PPP. Subsequently, there have been several empirical studies which model the adjustment of real exchange rates toward PPP deviations as a nonlinear process. These studies used recently developed econometric techniques (see, Baum et al., 2001; Coakley and Fuertes, 2001; Enders and Dibooglu, 2001 and Chen and Wu, 2000). …

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