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Does the purchasing power parity theory still hold ? The UK as the case study

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  • Ashraf, Kamran
  • Masih, Mansur

Abstract

The purchasing power parity (PPP) theory is an integral part of international finance. The PPP examines the relationship between the inflation rate differential between two countries and their exchange rate movements. The purpose of this study is to investigate whether the PPP still holds or not. The UK is taken as a case study. The standard time series techniques are employed to address the issue. Our findings tend to indicate that the PPP theory does hold in the long run as evidenced in the cointegration (or comovement) of the exchange rate and price ratio variable. Furthermore, the Granger-causality analysis unveils that an exogenous shock to the US-UK exchange rate disturbs the long run equilibrium and the domestic-foreign price ratio variable bears the brunt of short-run adjustment to bring about the long run PPP equilibrium. The exchange rate is found to be the exogenous leading variable and the price ratio variable is found to play the role of a follower in terms of endogenous adjustment. The findings have strong policy implications for international trade and investment.

Suggested Citation

  • Ashraf, Kamran & Masih, Mansur, 2017. "Does the purchasing power parity theory still hold ? The UK as the case study," MPRA Paper 100764, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:100764
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    References listed on IDEAS

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    More about this item

    Keywords

    exchange rate; domestic price; foreign price; cointegration; VECM; VDC;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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