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The Concept of PPP

In accordance with Deaton and Dupriez (2011), the concept of purchasing power parity is related to the adjustments that are required to be made within the exchange rate of the currencies of two different countries to bring them at the similar level of purchasing power of one another. The main aim of PPP is the comparison of the income levels in different countries, which makes it convenient to study and comprehend the main economic information about each country.

(Meyskens, Robb‐Post, Stamp, Carsrud and Reynolds, 2010). In the view of Prodan (2012); however, one of the major criticism of the theory is that it stresses upon the direct relationship between the purchasing capacity of the currencies of two economies; whereas, practically there is no such link between these elements.

Furthermore, it has been suggested that apart from the purchasing power of currencies, factors such as rate of tariff, speculations in the market along with the rate of capital flow has a significant impact on the rate of exchange of the countries (Prodan, 2012).

In the view of Qian (2010), purchasing power parity can take two different such as the absolute form of PPP and the other type is the relative form. It is further stated that the absolute form highlights that similar commodities in different countries needs to be priced on equal terms when measured through the same currency.

This form of PPP is also referred to as the law of one price. In the relative form of PPP, market imperfections are taken into consideration such as tariffs, transportation etc. (Özkan, 2013). Explain both the statistical and economic According to Alba and Papell (2007), the concept of PPP is an extension of the concept of law of one price. The law of one price illustrates that the price of a commodity or an asset will be same when the exchange rates of different countries are considered. In accordance with Taylor (2003), the theory of purchasing power parity is based on the following equation:

S₁ / S₀ = [(1 + I_y) / (1 + I_x)]

The equation shows that the currency exchange rate between two countries is determined by the difference of inflation between the two countries as inflation leads to a reduction in real purchasing power of a currency (Taylor, 2003).

Problems and Issues Associated with Purchasing Power Parity

One of the most important statistical issues is related to the adoption of the effective measurement techniques to identify whether the PPP concept has been effectively implemented or not (Alba and Papell, 2007). In the opinion of Taylor (2013), one of the major statistical difficulties in this case is related to multilateral comparisons when more than two countries are compared under the PPP concept.

Furthermore, the statistical capacities of the countries that have been involved in this scenario are also critical in measuring the condition of PPP. It must be noted that the nominal exchange rates follow Explain both the statistical and economic a random walk or non-stationary trend and on the other hand, the PPP concept perceives that the logarithm of the real exchange rate must be zero. Therefore, this is also a statistical problem due to which the stationary tests such as the autocorrelation is not applied to the PPP model and exchange rates (Taylor, 2013). In the view of Voinea (n.d.),

it is noticeable aspect of the basic PPP equation that the differences between the inflation rate in foreign economy and domestic economy (If – Id) is also non-stationary time series. Explain both the statistical and economic Considering the non-stationary nature of (If-Id) and real exchange rates, the autocorrelation is not applied to the PPP model. Apart from it, the non-stationary nature of difference between the inflation rates of two economies also leads to higher error terms of the model. A real case depicting the statement is shown in the figure below:

Figure 1 – Actual and Tradable PPP

(Source: Grips. Ac, 2015)

The above presented graph highlights the graph that is related to purchasing power parity condition between US and China. The above presented graph indicates that apart from the autocorrelation model there is a significant impact and difference between Actual and the tradable PPP and the differences can arise due to different reasons such as fluctuations in the economy and prices of goods etc. (Grips. Ac, 2015).

In the view of Taylor (2006), considering the dynamic nature of the modern economic environment, there are certain economic issues as well that are critical in the effective implementation of the purchasing power parity condition. One of the major issues that are related to its effective implementation is the difference in the methods of measurement of the price levels in different countries.

Furthermore, changes in the relative prices of tradable and non-tradable items in different countries which occur as a result of the preferences of the consumers would lead towards the changes in purchasing power parity condition. Further economic issue that is related to the testing of the PPP condition is the overall difference in the quality and after sales service that is provided with a particular product which makes it unable to compare different products and their prices (Taylor, 2006).

The direct exchange rate of the currency of a particular country has a positive impact on local inflation and a negative impact on the inflation of a foreign country. It has been further suggested that PPP to certain extent highlights that differentials of inflation have a significant impact on the movement of the exchange rate (Nurunnabi, 2014). Further, according to the literature of Nurunnabi (2014), majority of the empirical investigations have focused on long-run PPP. It is further stated that this empirical investigation includes conducting tests for unit roots in the real exchange rates….