PURCHASE POWER PARITY (PPP) IN RELATION TO CONSUMER PRICES.   Term Paper ID:30121 Click to get this paper

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Paper Abstract: Tests the PPP hypothesis using four European Community (EC) member states (France, Germany, Italy, UK). PPP theory. Discusses underlying bases of the PPP model; exchange rates assumptions; trading patterns & rate of inflation. Problems with use of the model. Method of research design. Results. Summary & conclusions. Four Exhibits. Paper Introduction: TESTING THE PURCHASING POWER PARITY HYPOTHESIS OVER THE LONG-TERM IN RELATION TO CONSUMER PRICES IN FRANCE, GERMANY, ITALY, AND THE UNITED KINGDOM Introduction This study tested the purchasing power parity (PPP) hypothesis in relation to consumer prices in four European Community (EC) member states. A background discussion on the PPP model follows this introduction. An explanation of the method used in this research follows the background discussion, a presentation of the data follows the explanation of the method, and the results of the research performed follow the presentation of the data. Background Discussion The underlying basis of the PPP model a contention that rela Text of the Paper: The entire text of the paper is shown below. However, the text is somewhat scrambled. We want to give you as much information as we possibly can about our papers and essays, but we cannot give them away for free. In the text below you will find that while disordered, many of the phrases are essentially intact. From this text you will be able to get a solid sense of the writing style, the concepts addressed, and the sources used in the research paper. It furtherassumes that shifts in trading patterns will cause changes in the relativerates of inflation between countries that will in turn maintain a long-termequilibrium in currency values. |?? The initial step involves the performance of unit root teststo assess non-stationarity. In the real world, such priceseries are not available. (1993, November). This approach holds that anincrease in the money supply should leave equilibrium relative pricesunchanged and should increase all prices by the same amount. Multivariate cointegrationanalysis and the long-run validity of PPP. Economic Commentary, 1-4. 1 |1 1.49 |1 3.96 |1 2.45 ||1997 |1 3.23 |1 3.27 |1 6. |?? One of the problems associated with use of the PPP model is thetechnical difficulty involved in deriving acceptable estimates ofequilibrium exchange rates. Krugman, P. 9 |1 5.66 ||1998 |1 3.93 |1 4.26 |1 8.17 |1 9.27 ||Source: The World Bank, 1999. Data Presentation Exhibit 1 presents the currency exchange rate values for each of thefour countries included in the research design for the 21-year period ofanalysis. S. Cointegration exists when thereexists some linear combination that transforms the residuals to a I( )series. F., & Karamouzis, N. 1 |62.85 |65.62 ||1987 |81.53 |8 .2 |65.82 |68.35 ||1988 |83.73 |81.22 |69.19 |71.7 ||1989 |86.66 |83.48 |73.49 |77.29 ||199 |89.58 |85.73 |78.27 |84.61 ||1991 |92.47 |87.1 |83.2 |89.57 ||1992 |94.65 |91.5 |87.42 |92.91 ||1993 |96.65 |95.58 |91.34 |94.36 ||1994 |98.25 |98.19 |95. Frenkel, J. The critical value for the rejection of the null hypothesisin the Engle-Granger test is -3.37 at p <. (1987, March). 5. On long- and short-runpurchasing power parity. Applied Economic Letters, 1(6), 99-1 2. 7 |57. If the null hypothesis ofno cointegration is valid, the residuals are I(1) and should approximatezero. The Engel and Granger (1987) cointegration method provided thestatistical framework for testing the PPP hypothesis. |?? It furtherassumes that shifts in trading patterns will cause changes in the relativerates of inflation between countries that will in turn maintain a long-termequilibrium in currency values. 9 | .62 ||199 |5.45 |1.62 |1198.1 | .56 ||1991 |5.64 |1.66 |124 .61 | .57 ||1992 |5.29 |1.58 |1232.41 | .57 ||1993 |5.66 |1.65 |1573.67 | .67 ||1994 |5.55 |1.62 |1612.44 | .65 ||1995 |4.99 |1.43 |1628.93 | .63 ||1996 |5.12 |1.5 |1542.95 | .64 ||1997 |5.84 |1.73 |17 3.1 | .61 ||1998 |5.9 |1.75 |172 .13 | .6 ||Source: The World Bank, 1999. ||1996 |1 2. The theory of purchasing power parity is relatively simple, and positsthat applying the law of one price to a comparable market basket of goodsand services across countries defines exchange rates between the countries. Dornbusch, R. |? Dockery, E., & Georgellis, Y. Hakkio [1984] foundevidence to support PPP in the long-run analyzing date from the 197 s, asdid Dockery and Georgellis [1994] using data for the 198 -1992 time-period. An assumption that such factors remain constant overtime, however, permits the absolute purchasing power parity hypothesis towork. Few studies have found evidence for thetheory in the short run, while the results of tests of the PPP hypothesisbased on long-run data produced mixed outcomes. MacDonald, R., & Marsh, I. Kugler, P., & Lenz, C. 7 | .61 ||1988 |5.96 |1.76 |13 1.63 | .56 ||1989 |6.38 |1.88 |1372. The base years for the CPIindex values for each of the four countries is 1995, e.g., 1995=1 . 2 ||198 |48.63 |66.23 |31.23 |44.85 ||1981 |55.11 |7 .42 |36.79 |5 .18 ||1982 |61.71 |74.13 |42.81 |54.49 ||1983 |67.55 |76.55 |49. W. This method is a two-step process. Alldata are from the World Bank database. (1994). Exhibit 3 presents the results ofthese tests.|Exhibit 3 - Results of Unit Root Tests || |? References Cheung, Y-W., & Lai, K. The PPP hypothesis testapplied to each of the four EU countries included in the research design. Long-run purchasing powerparity: The case of Greece 198 -1992. | | ||Ita |-5.26 |-5.3 |-3.25 |-3.85 |-4.64 |-6.8 | | ||UK |-5.84 |-5.78 |-4.7 |-4.66 |-6.76 |-7.25 | | ||* = Null (non-stationary) hypothesis rejected | As the data presented in Exhibit 3 indicate, it was possible to rejectthe null (non-stationary) hypothesis. Under the alternative hypothesis of stationarity, the value shouldbe negative to a statistically significant extent. The PPP hypothesis states that the percentage exchange ratedepreciation is equal to the difference between domestic and foreigninflation. |1 . The results of the research performed for this study confirmed thepresence of cointegration for each of the four EU countries. The second step is the Engle-Granger test ofcointegration. Long-run analyses tend to support the PPP hypothesis; however, such isnot the case with short-run analyses. |?? Thesecountries, all members of the EU, are France, Germany, Italy, and the UK.The period of analysis is 1978-1998 inclusive, a 21-year time-period. testing the purchasing power parity hypothesis over the long-term in relation to consumer prices in France, germany, italy, and the United kingdom Introduction This study tested the purchasing power parity (PPP) hypothesis inrelation to consumer prices in four European Community (EC) member states.A background discussion on the PPP model follows this introduction. The findingsconfirmed that the PPP hypothesis is valid in relation to the major EUcountries. All consumer price index values are annual data.|Exhibit 2 - Consumer Price Index Values [Base Year for All Four Countries ||= 1995 = 1 ] ||Year |France |Germany |Italy |United Kingdom||1978 |38.71 |6 .34 |22.46 |33.5 ||1979 |42.83 |62.82 |25.75 |38. These difficulties stem from (1)the use of different measure in inflation in various countries, and (2) theselection of a base period for analysis. In its simplest form, it states that in the absence of governmentintervention and significant freight charges and tariffs, aninternationally traded basket of similar goods should sell for the sameeffective price when converted into the same currency. Although simple intheory, real world complications such as differentiated products, tastes,and costly information can confound the testing of the PPP hypothesis. |1.14 |1.16 |1.18 |1.15 ||ADF |-3.5 |-3.52 |-3.56 |-3.51 || |* |* |* |* ||* = Null (no cointegration) hypothesis rejected | The results of the Engle-Granger test permitted the rejection of thenull hypothesis that no cointegration existed. |-3.3 |- .94 |-1.59 |-2.1 |- .42 |-3.48 |-3.51 || | | | | | | |* |* ||Differenced Values ||Fra |-5.6 |-5.65 |-4.1 |-4.21 |-5.95 |-6.84 | | ||Ger |-5.65 |-5.66 |-3.98 |-3.99 |-6.86 |-7. MacDonald, R. |?-? Some researchers contend that the failure to find a cointegratingrelationship between relative prices and an exchange rate likely is afunction of the econometric method used, as opposed to the actual absenceof a long-run relationship between the variables. Co-integration anderror correction: Representation, estimation, and testing. | Results of Testing the PPP Hypothesis The initial step in the data analysis to test the PPP hypothesis wasthe performance of the unit root tests. Ideally, a price series consisting of the prices of homogeneousinternationally traded goods is desirable. Long-run purchasing power parity: Isit for real? |1 . The underlying basis of the PPP model a contention that relative ratesof inflation determine long-range exchange rate changes. (198 ). All currency exchange rate values are annual data.|Exhibit 1 - Currency Exchange Rates [Local Currency Values per US$1] ||Year |France |Germany |Italy |United Kingdom||1978 |4.51 |2. This studymade no effort to test the PPP hypothesis over the short-term because thepreponderance of the studies reported in literature indicate that the PPPhypothesis is not valid over the short-term. W. F., & Granger, C. Humpage, O. J. The relative PPP hypothesis will still hold, however, if overallprices are homogeneous to a degree of one. Krugman [1978], Dornbusch (198 , and Frenkel (1981), however, foundevidence that did not support the PPP over the long-term. Review of Economics and Statistics, 75, 69 -695. The second step in the data analysis to test the PPP hypothesis wasthe performance of the Engle-Granger test. Econometric analysisof financial markets. 5. Brookings Papers onEconomic Activity, 1, 143-185. (1986, January 1). 1 |848.66 | .52 ||1979 |4.25 |1.83 |83 .86 | .47 ||198 |4.23 |1.82 |856.45 | .43 ||1981 |5.43 |2.26 |1136.77 | .5 ||1982 |6.57 |2.43 |1352.51 | .57 ||1983 |7.62 |2.55 |1518.85 | .66 ||1984 |8.74 |2.85 |1756.96 | .75 ||1985 |8.99 |2.94 |19 9.44 | .78 ||1986 |6.93 |2.17 |149 .81 | .68 ||1987 |6. Method The research design for this study includes four countries. Lastly, the problems associatedwith the use of the PPP model involve the model's inability to account forfactors other than inflation, which also affect currency exchange rates(Humpage & Karamouzis, 1986). |q || |?? Collapse of purchasing power parity during the197 s." European Economics Review, 16, 145-165. Without such estimates, meaningful assessmentsof exchange rate level are not possible. The Engle-Granger (1987) cointegration method involves the applicationof ordinary least squares (OLS) to the data, and then applying theAugmented Dickey-Fuller test to the residuals. Review of Economics andStatistics, 75, 18 -184. The PPP model also assumes that exchange rates will fluctuate withrespect to relative rates of price inflation between countries. The critical value for the rejection of the null hypothesisin the Engle-Granger test is -3.37 at p <. If the variables are all first-order, non-stationary in the test ofthe PPP hypothesis, the integration is an order of 1. The initial step involves the performance of unit root teststo assess non-stationarity. Econometrica,55, 251-176. Heidelberg, Germany: Physica-Verlag, 23-46. Thus, consumer price indexes (CPIs) and producerprice indexes (PPIs) typically represent prices in the testing of the PPPhypothesis. Cheung and Lai (1993),Kugler and Lenz (1993), MacDonald (1993), and MacDonald and Marsh (1994a)contend that the Johansen cointegration method to test for the number ofcointegrating vectors among relative prices and exchange rates solves thisproblem. |?? (1981). ||1984 |72.73 |78.4 |54.4 |59.82 ||1985 |76.98 |8 .11 |59.41 |63.45 ||1986 |78.93 |8 . |?? Journal of International Economics, 34, 181-192. Exhibit 4 presents the resultsof this test.|Exhibit 4 - Results of the Engle-Granger Test || |France |Germany |Italy |UK ||? (1992). |?? As each of these measures typically include non-traded goods,however, the degree of symmetry and proportionality desired frequently arenot attained through the testing of the hypothesis. A correct valuefor the dollar? The Engel and Granger (1987) cointegration method provided thestatistical framework for testing the PPP hypothesis. This method is a two-step process. Long-run purchasing powerparity during the recent float. The literature contains mixed results relative to the testing of thevalidity of the PPP hypothesis. The assumption isthat exchange rates adjust in a way that insures that, subsequent toconversion into another currency, a currency in question will purchasegoods and services in a foreign country equivalent to that which it couldpurchase in the domestic economy. A restructuring of the hypothesis states that the change in thereal exchange rate, conditional on relative PPP holding, will result in thelogarithmic real exchange rate change equaling zero. | Exhibit 2 presents the consumer price index values for each of thefour countries included in the research design for the 21-year period ofanalysis. The assumption isthat exchange rates adjust in a way that insures that, subsequent toconversion into another currency, a currency in question will purchasegoods and services in a foreign country equivalent to that which it couldpurchase in the domestic economy. Engle, R. 2 |96.7 ||1995 |1 . The PPP hypothesis states that the percentage exchange ratedepreciation is equal to the difference between domestic and foreigninflation. Thus,an increase in the domestic price level in one of the two countries shouldresult in a proportionate depreciation of the exchange rate between the twocountries. If there is a long-run relationship between an exchange rate andrelative prices, the appropriate method for the validation of therelationship is cointegration analysis. A. The condition of absolute PPP usually involves a two-country settingin which the two countries each produce a range of homogeneous traded goodswherein the concept of a single price holds for each of the goods. The restrictive character of the absolute PPP hypothesis issuch that even if it were possible to construct prices in the mannersuggested by the hypothesis, the existence of transportation costs andother impediments to trade would interfere with the functioning of thehypothesized process. (1993, February). Is purchasing power parity a useful guide to thedollar> Economic Review (Federal Reserve Bank of Kansas City), 77, 37-52. 1 |1.8 |1296. The results permitted therejection of the null hypothesis for each of the four EU countries includedin the analysis Summary and Conclusion This study tested the purchasing power parity hypothesis in relationto consumer prices in four European Community member states. In its simplest form, it states that in the absence of governmentintervention and significant freight charges and tariffs, aninternationally traded basket of similar goods should sell for the sameeffective price when converted into the same currency. Background Discussion The underlying basis of the PPP model a contention that relative ratesof inflation determine long-range exchange rate changes. 5 |-1.61 |-2.22 |- .52 |-3.49 |-3.5 || | | | | | | |* |* ||Ger |-2.26 |-3.48 |- .87 |-1.65 |-2.21 |- .49 |-3.5 |-3.52 || | | | | | | |* |* ||Ita |-2.3 |-3.48 |-1.21 |-1.28 |-1.5 |- .5 |-3.54 |-3.56 || | | | | | | |* |* ||UK |-2. The data that provided the basis for this test of the PPPhypothesis covered a period of 21 year. Hakkio, C. The theory of purchasing power parity is relatively simple, and positsthat applying the law of one price to a comparable market basket of goodsand services across countries defines exchange rates between the countries. It was possible to reject the nullhypothesis for each of the four EU countries included in the analysis. The PPP hypothesis testapplied to each of the four EU countries included in the research design. (1994). (1993, February). The PPP model also assumes that exchange rates will fluctuate withrespect to relative rates of price inflation between countries. ||Level Values ||Fra |-2.32 |-3.37 |-1. The countriesincluded in the research design were France, Germany, Italy, and the UnitedKingdom. If there is no long-run relationship between the exchange rate and relative prices, theresidual series also is non-stationary. Exchange rate economics. S. Currency exchange rates for each of the four countries reflect localcurrency values per one United States dollar. Purchasing power parity and exchange rates.Journal of International Economics, 8, 397-4 7. V. |1 . The second step is the Engle-Granger test ofcointegration. In Kaehlet, J., & Kugler, P. Anexplanation of the method used in this research follows the backgrounddiscussion, a presentation of the data follows the explanation of themethod, and the results of the research performed follow the presentationof the data. Tests of the PPP hypothesis requirethe selection of appropriate data sets for the determination of relativeprices. (1978). (Eds.). Therefore, the results of thistest of the PPP hypothesis also confirmed the findings reported in theliterature that validate the PPP hypothesis over the long-term. Thevariables are (1) currency exchange rates for each of the four countriesand (2) consumer price index values for each of the four countries. A restructuring of the hypothesis states that the change in thereal exchange rate, conditional on relative PPP holding, will result in thelogarithmic real exchange rate change equaling zero. If this paper is not what you are looking for, you can search again: Search for: or Click here to request an essay written just for you.