Purchasing Power Parity
EXECUTIVE SUMMARY:
There has been a long standing controversy among the economist about the validity of PPP (Purchasing Power Parity) in the long run. The parity reveals that prices in two different economies should be identical to each other when they expressed in terms of the same currency. It is a central building block in the monetary models of exchange rate determination. One of the most common practices, to test the validity of PPP is through unit root test of real exchange rate. In this paper unit root test has been done based on the data on Bangladesh and its major trading partner India, to see whether exchange rate has unit root or not. It has been found out that the PPP holds i.e. real exchange is not trend stationary in the long run, at a certain significance level. So the null hypothesis that real exchange root has unit root has been rejected. This paper should be seen as an exploratory study on this subject.
Introduction
The Purchasing Power Parity (PPP) theory, sometimes called the ‘inflation theory of exchange rates’ can be traced back to the Salamanca school in sixteenth century
Spain, and in the writing of Gerrard de Malynes which appeared in 1601 in England. Though Keynes gave credit to David Ricardo for the concept of PPP, Swedish economist Gustav Cassel was first to name the theory PPP. After World War I, Cassel became the outstanding protagonist of the theory. He used it in order to estimate the equilibrium exchange rates at which nations could return to the gold standard after the disruption of international trade and the large changes in relative commodity prices in the various nations caused by World War 1. Purchasing power parity (PPP) exchange rate is the exchange rate between two currencies that would equate the two relevant national price levels if expressed in a common currency at that rate, so that the purchasing power of a unit of one currency would be the same in both economies
The question of whether Purchasing Power Parity
There has been a long standing controversy among the economist about the validity of PPP (Purchasing Power Parity) in the long run. The parity reveals that prices in two different economies should be identical to each other when they expressed in terms of the same currency. It is a central building block in the monetary models of exchange rate determination. One of the most common practices, to test the validity of PPP is through unit root test of real exchange rate. In this paper unit root test has been done based on the data on Bangladesh and its major trading partner India, to see whether exchange rate has unit root or not. It has been found out that the PPP holds i.e. real exchange is not trend stationary in the long run, at a certain significance level. So the null hypothesis that real exchange root has unit root has been rejected. This paper should be seen as an exploratory study on this subject.
Introduction
The Purchasing Power Parity (PPP) theory, sometimes called the ‘inflation theory of exchange rates’ can be traced back to the Salamanca school in sixteenth century
Spain, and in the writing of Gerrard de Malynes which appeared in 1601 in England. Though Keynes gave credit to David Ricardo for the concept of PPP, Swedish economist Gustav Cassel was first to name the theory PPP. After World War I, Cassel became the outstanding protagonist of the theory. He used it in order to estimate the equilibrium exchange rates at which nations could return to the gold standard after the disruption of international trade and the large changes in relative commodity prices in the various nations caused by World War 1. Purchasing power parity (PPP) exchange rate is the exchange rate between two currencies that would equate the two relevant national price levels if expressed in a common currency at that rate, so that the purchasing power of a unit of one currency would be the same in both economies
The question of whether Purchasing Power Parity