Skip to main content
SpringerLink
Log in

Purchasing Power Parity: A Survey of the Issues

  • Chapter
The Big Mac Index

Abstract

The purchasing power parity (PPP) doctrine, one of the most widely researched areas in international finance, is also probably one of the most controversial in the theory of exchange rate determination. According to the theory of purchasing power parity, the rate of exchange between two currencies is determined by the differences in the price levels of their respective countries. However, while proponents of the theory argue that PPP provides a strong basis for determining exchange rates, others have contended otherwise, with a plethora of empirical research demonstrating persistent deviations from PPP. Consequently, we provide a survey of the issues that contribute to the problems in testing the theory. Notably, factors such as the lack of uniformity in the price indices used to determine the long-run equilibrium exchange rate — also known as the ‘index-number problem’ — and the issue of productivity bias, which is probably seen as the most serious criticism of PPP theory, are discussed. We also consider the role of market imperfections as well as structural changes in the economy.

This is a preview of subscription content, log in via an institution to check access.

Access this chapter

Log in via an institution
Chapter
USD 29.95
Price excludes VAT (USA)
  • Available as PDF
  • Read on any device
  • Instant download
  • Own it forever
eBook
USD 84.99
Price excludes VAT (USA)
  • Available as PDF
  • Read on any device
  • Instant download
  • Own it forever
Softcover Book
USD 109.99
Price excludes VAT (USA)
  • Compact, lightweight edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info
Hardcover Book
USD 109.99
Price excludes VAT (USA)
  • Durable hardcover edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info

Tax calculation will be finalised at checkout

Purchases are for personal use only

Institutional subscriptions

Preview

Unable to display preview. Download preview PDF.

Unable to display preview. Download preview PDF.

References

  • Abuaf, N. and P. Jorion (1990) ‘Purchasing Power Parity in the Long Run’, Journal of Finance, vol. 45, pp. 157–74.

    Article  Google Scholar 

  • Adler, M. and B. Dumas (1983) ‘International Portfolio Choice and Corporation Finance: A Synthesis’, Journal of Finance, vol. 38, pp. 925–84.

    Article  Google Scholar 

  • Adler, M. and B. Lehmann (1983) ‘Deviations from Purchasing Power Parity in the Long Run’, Journal of Finance, vol. 38, pp. 1471–87.

    Article  Google Scholar 

  • Angell, J. W. (1925) ‘Monetary Theory and Monetary Policy: Some Recent Discussions’, Quarterly Journal of Economics, vol. 39, pp. 267–99.

    Article  Google Scholar 

  • Artus, J. R. (1978) ‘Methods of Assessing the Long-run Equilibrium Value of an Exchange Rate’, Journal of International Economics, vol. 8, pp. 277–99.

    Article  Google Scholar 

  • Bacha, E. and L. Taylor (1971) ‘Foreign Exchange Shadow Prices: A Critical Review of Current Theories’, Quarterly Journal of Economics, vol. 85, pp. 197–224.

    Article  Google Scholar 

  • Bahmani-Oskooee, M. (1992) ‘A Time-Series Approach to Test the Productivity Bias Hypothesis in Purchasing Power Parity’, Kyklos, vol. 45, pp. 227–36.

    Article  Google Scholar 

  • Balassa, B. (1964) ‘The Purchasing-Power Parity Doctrine: A Reappraisal’, Journal of Political Economy, vol. 72, pp. 584–96.

    Article  Google Scholar 

  • Bartolini, L. (1995) ‘Purchasing Power Parity Measures of Competitiveness’, Finance and Development, September, pp. 46–9.

    Google Scholar 

  • Betton, S., M. D. Levi and R. Uppal (1995) ‘Index-Induced Errors and Purchasing Power Parity: Bounding the Possible Bias’, Journal of International Financial Markets, Institutions and Money, vol. 5, pp. 165–79.

    Google Scholar 

  • Bunting, F. H. (1939) ‘The Purchasing Power Parity Theory Re-Examined’, Southern Economic Journal, vol. 5, pp. 282–301.

    Article  Google Scholar 

  • Cassel, G. (1916a) ‘The Present Situation of the Foreign Exchanges’, Economic Journal, vol. 26, pp. 62–5.

    Article  Google Scholar 

  • Cassel, G. (1916b) ‘The Present Situation of the Foreign Exchanges’, Economic Journal, vol. 26, pp. 319–23.

    Article  Google Scholar 

  • Cassel, G. (1921) The World’s Monetary Problems. London: Constable.

    Google Scholar 

  • Cassel, G. (1922) Money and Foreign Exchange After 1914. London: Constable.

    Google Scholar 

  • Cassel, G. (1926) ‘Exchanges, Foreign’, Encyclopedia Britannica, Supplementary Vol. 1, 13th edn, pp. 1086–9.

    Google Scholar 

  • Cassel, G. (1928) ‘The International Movements of Capital’, in Foreign Investments, pp. 1–93. Chicago: University of Chicago Press.

    Google Scholar 

  • Cassel, G. (1932) The Theory of Social Economy, rev edn. New York: Harcourt Brace.

    Google Scholar 

  • Clague, C. and V. Tanzi (1972) ‘Human Capital, Natural Resources and the Purchasing-Power Parity Doctrine: Some Empirical Results’, Economia Intemazionale, vol. 25, pp. 3–18.

    Google Scholar 

  • Clements, K. W. and M. Semudram (1983) ‘An International Comparison of the Price of Nontraded Goods’, Weltwirtschaftliches Archiv, vol. 119, pp. 356–63.

    Article  Google Scholar 

  • De Gregorio, J., A. Giovannini and H.C. Wolf (1994) ‘International Evidence on Tradeables and Nontradeables Inflation’, European Economic Review, vol. 38, pp. 1225–44.

    Article  Google Scholar 

  • de Vries, M. G. (1968) ‘Exchange Depreciation in Developing Countries’, IMF Staff Papers, no. 15, pp. 560–78.

    Article  Google Scholar 

  • Diebold, F. X., S. Husted and M. Rush (1991) ‘Real Exchange Rates under the Gold Standard’, Journal of Political Economy, vol. 99, pp. 1252–71.

    Article  Google Scholar 

  • Dornbusch, R. (1976) ‘Expectations and Exchange Rate Dynamics’, Journal of Political Economy, vol. 84, pp. 1161–76.

    Article  Google Scholar 

  • Dornbusch, R. (1987) ‘Purchasing Power Parity’, in The New Palgrave: A Dictionary of Economics, eds J. Eatwell, M. Milgate and P. Newman, pp. 1075–85. London: Palgrave Macmillan.

    Google Scholar 

  • Edwards, S. (1989) Real Exchange Rate, Devaluation and Adjustment. Cambridge: MIT Press.

    Google Scholar 

  • Engel, C. and J.H. Rogers (1996) ‘How Wide is the Border?’, American Economic Review, vol. 86, pp. 1112–25.

    Google Scholar 

  • Frankel, J. A. (1985) ‘Six Possible Meanings of “Overvaluation”: The 1981–85 Dollar’, Essays in International Finance, no. 159. Princeton: Princeton University Press.

    Google Scholar 

  • Frankel, J. A. (1994) ‘Introduction’, in The Internationalization of Equity Markets, pp. 1–20. Chicago: University of Chicago Press.

    Chapter  Google Scholar 

  • Frankel, J. A. and R. Meese (1987) ‘Are Exchange Rages Excessively Variable?’, in NBER Macroeconomics Annual, ed. Stanley Fischer, pp. 117–53. Cambridge: MIT Press.

    Google Scholar 

  • Frenkel, J. A. (1976) ‘A Monetary Approach to the Exchange Rate: Doctrinal Aspects and Empirical Evidence’, Scandinavian Journal of Economics, vol. 78, pp. 200–24.

    Article  Google Scholar 

  • Frenkel, J. A. (1978) ‘Purchasing Power Parity: Doctrinal Perspective and Evidence from the 1920s’, Journal of International Economics, vol. 8, pp. 169–91.

    Article  Google Scholar 

  • Frenkel, J. A. (1981) ‘The Collapse of Purchasing Power Parities during the 1970s’, European Economic Review, vol. 16, pp. 145–65.

    Article  Google Scholar 

  • Frenkel, J. A. and M. L. Mussa (1980) ‘The Efficiency of Foreign Exchange Markets and Measures of Turbulence’, American Economic Review, vol. 70, pp. 374–81.

    Google Scholar 

  • Froot, K. A. and K. Rogoff (1995) ‘Perspectives on PPP and Long-Run Real Exchange Rates’, in Handbook of International Economics, eds G. Grossman and K. Rogoff, vol. 3, pp. 1647–88. Amsterdam: North-Holland Press.

    Google Scholar 

  • Ghosh, A. R. and H. C. Wolf (1994) ‘Pricing in International Markets: Lessons from The Economist’. NBER Working Paper Series, no. 4806, National Bureau of Economic Research, Cambridge, Massachusetts.

    Google Scholar 

  • Goldstein, M. and L. H. Officer (1979) ‘New Measures of Prices and Productivity for Tradeable and Nontradeable Goods’, The Review of Income and Wealth, vol. 25, pp. 413–27.

    Article  Google Scholar 

  • Hagen, E. E. (1957) ‘Comment’, in Problems in the International Comparison of Economic Accounts, pp. 377–88. Princeton: Princeton University Press.

    Google Scholar 

  • Harris, S. E. (1936) ‘Measures of Currency Overvaluation and Stabilization’, Explorations in Economics, pp. 35–45. New York: McGraw-Hill.

    Google Scholar 

  • Harrod, R. F. (1939) International Economics. Cambridge: Nisbet & Co.

    Google Scholar 

  • Holmes, J. M. (1967) ‘The Purchasing-Power-Parity Theory: In Defence of Gustav Cassel as a Modern Theorist’, Journal of Political Economy, vol. 75, pp. 686–95.

    Article  Google Scholar 

  • Houthakker, H. S. (1962) ‘Exchange Rate Adjustment’, in Factors Affecting the United States Balance of Payments, pp. 287–304, Compilation of studies prepared for the Subcommittee on International Exchange Payments, Joint Economic Committee, 87th Congress, 2nd Session. Washington, DC: US Government Printing Office.

    Google Scholar 

  • Huizinga, J. (1987) ‘An Empirical Investigation of the Long-Run Behavior of Real Exchange Rates’, Carnegie-Rochester Series on Public Policy, vol. 27, pp. 149–215.

    Article  Google Scholar 

  • Isenman, P. (1980) ‘Inter-Country Comparison of “Real” (PPP) Incomes: Revised Estimates and Unresolved Questions’, World Development, vol. 8, pp. 61–72.

    Article  Google Scholar 

  • Keynes, J. M. (1930) A Treatise on Money Reform. London: Palgrave Macmillan.

    Google Scholar 

  • Keynes, J. M. (1930) A Treatise on Money, vol. 1. London: Palgrave Macmillan.

    Google Scholar 

  • Kravis, I. B. (1986) ‘The Three Faces of the International Comparison Project’, Research Observer, vol. 1, pp. 3–26.

    Article  Google Scholar 

  • Kravis, I. B., A. W. Heston and R. Summers (1978) in collaboration with A. Civitello, International Comparisons of Real Product and Purchasing Power. Baltimore: Johns Hopkins Press.

    Google Scholar 

  • Kravis, I. B. and R. Lipsey (1978) ‘Price Behavior in the Light of Balance of Payments Theories’, Journal of International Economics, vol. 8, pp. 193–247.

    Article  Google Scholar 

  • Kravis, I. B., Z. Kennessey, A. W. Heston and R. Summers (1975) A System of International Comparisons of Gross Products and Purchasing Power. Baltimore: Johns Hopkins Press.

    Google Scholar 

  • Krugman, P. R. (1990a) ‘Equilibrium Exchange Rates’, in International Policy Coordination and Exchange Rate Fluctuations, eds W. H. Branson, J. A. Frenkel and M. Goldstein, pp. 159–95. Chicago: University of Chicago Press.

    Google Scholar 

  • Krugman, P. R. (1990b) ‘Hindsight on the Strong Dollar’, in The Economics of the Dollar Cycle, eds S. Gerlach and P. A. Petri, pp. 82–118. Cambridge: MIT Press.

    Google Scholar 

  • Lothian, J. R. (1990) ‘A Century Plus of Japanese Exchange Rate Behavior’, Japan and the World Economy, vol. 2, pp. 47–70.

    Article  Google Scholar 

  • Lothian, J. R. (1997) ‘Multi-Country Evidence on the Behavior of Purchasing Power Parity under the Current Float’, Journal of International Money and Finance, vol. 16, pp. 19–35.

    Article  Google Scholar 

  • Maddison, A. (1983) ‘A Comparison of the Levels of GDP per Capita in Developed and Developing Countries, 1790–1980’, Journal of Economic History, vol. 43, pp. 27–41.

    Article  Google Scholar 

  • Manzur, M. (1990) ‘An International Comparison of Prices and Exchange Rates: A New Test of Purchasing Power Parity’, Journal of International Money and Finance, vol. 9, pp. 75–91.

    Article  Google Scholar 

  • Meese, R. (1990) ‘Currency Fluctuations in the Post-Bretton Woods Period’, Journal of Economic Perspectives, vol. 4, pp. 117–34.

    Article  Google Scholar 

  • Meese, R. and K. Rogoff (1988) ‘Was It Real? The Exchange Rate Interest Differential Relation Over the Modern Floating Exchange Rate Period’, Journal of Finance, vol. 43, pp. 933–48.

    Article  Google Scholar 

  • Michael, P., A. R. Nobay and D. Peel (1994a) ‘Purchasing Power Parity Yet Again: Evidence from Spatially Separated Commodity Markets’, Journal of International Money and Finance, vol. 13, pp. 637–57.

    Article  Google Scholar 

  • Michael, P., A. R. Nobay and D. Peel (1994b) ‘Exchange Rates, Transactions Bands and Cassell’s Doctrine of PPP’, Liverpool Research Papers in Economics and Finance, no. 9403, Department of Economics and Accounting, University of Liverpool.

    Google Scholar 

  • Miller, S. (1984) ‘Purchasing Power Parity and Relative Price Variability’, European Economic Review, vol. 26, pp. 353–67.

    Article  Google Scholar 

  • Mussa, M. L. (1986) ‘Nominal Exchange Rate Regimes and the Behaviour of Real Exchange Rates: Evidence and Implications’, Carnegie-Rochester Conference Series on Public Policy, vol. 25, pp. 117–214.

    Article  Google Scholar 

  • Myhrman, J. (1976) ‘Experiences of Flexible Exchange Rates in Earlier Periods: Theories, Evidence and a New View’, Scandinavian Journal of Economics, vol. 78, pp. 169–96.

    Article  Google Scholar 

  • Officer, L. H. (1974) ‘Purchasing Power Parity and Factor Price Equalization’, Kyklos, vol. 27, pp. 868–78.

    Article  Google Scholar 

  • Officer, L. H. (1976a) ‘The Purchasing-Power-Parity Theory of Exchange Rates: A Review Article’, IMF Staff Papers, no. 23, pp. 1–60.

    Article  Google Scholar 

  • Officer, L. H. (1976b) ‘The Productivity Bias in Purchasing Power Parity: An Econometric Investigation’, IMF Staff Papers, no. 23, pp. 545–79.

    Article  Google Scholar 

  • Officer, L. H. (1982) ‘Purchasing Power Parity and Exchange Rates: Theory, Evidence and Relevance’, in Contemporary Studies in Economic and Financial Analysis, eds E. I. Altman and I. Walter, vol. 35. Connecticut: JAI Press.

    Google Scholar 

  • Pick, D. H. and T. L. Volrath (1994) ‘Real Exchange Rate Misalignment and Agricultural Export Performance in Developing Countries’, in Economic Development and Cultural Change, pp. 555–71. Chicago: University of Chicago Press.

    Google Scholar 

  • Pigou, A. C. (1922) ‘The Foreign Exchanges’, Quarterly Journal of Economics, vol. 37, pp. 52–74.

    Article  Google Scholar 

  • Ricardo, D. (1810/11) The High Price of Bullion, reprinted in Sraffa (1951), vol. III, pp. 47–127.

    Google Scholar 

  • Ricardo, D. (1811a) Reply to Mr. Bosanquet’s Practical Observations on the Report of the Bullion Committee, reprinted in Sraffa (1951), vol. III, pp. 157–256.

    Google Scholar 

  • Ricardo, D. (1811b) Letter to [Malthus?], 23rd June 1811, reprinted in Sraffa (1952), vol. VI, pp. 29–30.

    Google Scholar 

  • Ricardo, D. (1811c) Letter to Malthus, 17 July 1811, reprinted in Sraffa (1952), vol. VI, pp. 25–40.

    Google Scholar 

  • Rogers, J. H. (1995) ‘Real Shocks and Real Exchange Rates in Really Long-Term Data’, International Finance Discussion Papers, no. 493, Board of Governors of the Federal Reserve System, Washington DC.

    Google Scholar 

  • Rogers, J. H. and M. Jenkins (1995) ‘Haircuts or Hysteresis? Sources of Movements in Real Exchange Rates’, Journal of International Economics, vol. 38, pp. 339–60.

    Article  Google Scholar 

  • Rogoff, K. (1996) ‘The Purchasing Power Parity Puzzle’, Journal of Economic Literature, vol. 34, pp. 647–68.

    Google Scholar 

  • Rothschild, K. (1958) ‘Actual and Implied Exchange Rates’, Scottish Journal of Political Economy, vol. 5, pp. 229–35.

    Article  Google Scholar 

  • Sadie, J. L. (1948) ‘Further Observations on Foreign Exchange Rates’, South African Journal of Economics, vol. 16, pp. 194–201.

    Article  Google Scholar 

  • Saidi, N. and A. Swoboda (1983) ‘Nominal and Real Exchange Rates: Issues and Some Evidence’, in Recent Issues in the Theory of Flexible Exchange Rates, eds E. Claassen and P. Salin, pp. 3–27. Amsterdam: North-Holland Press.

    Google Scholar 

  • Samuelson, P. A. (1964) ‘Theoretical Notes on Trade Problems’, Review of Economics and Statistics, vol. 46, pp. 145–54.

    Article  Google Scholar 

  • Sjaastad, L. (1991) PPP and the Real Exchange Rate: The Swiss Case, Discussion Paper no. 91-24, Department of Economics, University of Western Australia.

    Google Scholar 

  • Sraffa, P. (with M. H. Dobb) The Works and Correspondences of David Ricardo (1950- ). Cambridge: Cambridge University Press.

    Google Scholar 

  • Stockman, A. C. (1987) ‘The Equilibrium Approach to Exchange Rates’, Federal Reserve Bank of Richmond Economic Review, March, 12–31.

    Google Scholar 

  • Stockman, A. C. (1988) ‘Real Exchange Rate Variability Under Pegged and Floating Nominal Exchange Rate Systems: An Equilibrium Theory’, Carnegie-Rochester Conference Series on Public Policy, vol. 29, pp. 259–94.

    Article  Google Scholar 

  • Tamagna, F. M. (1945) ‘The Fixing of Foreign Exchange Rates’, Journal of Political Economy, vol. 53, pp. 57–72.

    Article  Google Scholar 

  • Taylor, M. P. (1995) ‘The Economics of Exchange Rates’, Journal of Economic Literature, vol. 33, pp. 13–47.

    Google Scholar 

  • Voltaire, K. and E. J. Stack (1980) ‘A Divisia Version of the Country-Product-Dummy Method’, Economics Letters, vol. 5, pp. 97–9.

    Article  Google Scholar 

  • Wheatley, J. (1803) Remarks on Currency and Commerce. London: Cadell & Davies.

    Google Scholar 

  • Wheatley, J. (1807) An Essay on the Theory of Money and Principles of Commerce. London: Cadell & Davies.

    Google Scholar 

  • Wheatley, J. (1819) Report on the Reports of the Bank Committees. London: Longman, Hurst, Rees, Orme & Brown.

    Google Scholar 

  • Williamson, J. (1983) The Exchange Rate System. Cambridge: MIT Press.

    Google Scholar 

  • Yeager, L. B. (1958) ‘A Rehabilitation of Purchasing-Power Parity’, Journal of Political Economy, vol. 66, pp. 516–30.

    Article  Google Scholar 

  • Yeager, L. B. (1976) International Monetary Relations: Theory, History, and Policy. New York: Harper & Row.

    Google Scholar 

Download references

Authors
  1. Li Lian Ong
    View author publications

    You can also search for this author in PubMed Google Scholar

Copyright information

© 2003 Li Lian Ong

About this chapter

Cite this chapter

Ong, L.L. (2003). Purchasing Power Parity: A Survey of the Issues. In: The Big Mac Index. Palgrave Macmillan, London. https://doi.org/10.1057/9780230512412_1

Download citation

Publish with us

Policies and ethics

Search

Navigation