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The Purchasing Power Parity Fallacy: Time to Reconsider the PPP Hypothesis

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  • Maria Eleftheriou

    (Universidad Autónoma de Madrid)

  • Nikolas A. Müller-Plantenberg

    (Universidad Autónoma de Madrid)

Abstract

Traded good prices affect the real exchange rate first through their effect on the overall price level and second through their effect on the nominal exchange rate. Whereas the price level effect, which is positive in sign, is universally recognized, the nominal exchange rate effect, which is negative in sign, is routinely ignored. We calculate to which extent real exchange rate changes are accounted for by traded good prices and other components of the real exchange rate. We find that the nominal exchange rate effect neutralizes the price level effect entirely, suggesting that, contrary to popular belief, good market arbitrage is not conducive to purchasing power parity (the purchasing power parity fallacy). Rather than traded or non-traded good prices, the main driving force behind the real exchange rate is currency market pressure, a variable that, as we argue, is largely determined by the cumulative trade and capital flows of a country.

Suggested Citation

  • Maria Eleftheriou & Nikolas A. Müller-Plantenberg, 2018. "The Purchasing Power Parity Fallacy: Time to Reconsider the PPP Hypothesis," Open Economies Review, Springer, vol. 29(3), pages 481-515, July.
    • Handle: RePEc:kap:openec:v:29:y:2018:i:3:d:10.1007_s11079-017-9473-9
    DOI: 10.1007/s11079-017-9473-9
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    2. Combes, Jean-Louis & Kinda, Tidiane & Ouedraogo, Rasmané & Plane, Patrick, 2019. "Financial flows and economic growth in developing countries," Economic Modelling, Elsevier, vol. 83(C), pages 195-209.

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    More about this item

    Keywords

    Real exchange rate accounting; Good market arbitrage; Purchasing power parity fallacy; Currency market pressure;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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