A REEXAMINATION OF PURCHASING POWER PARITY

This paper presents a systematic analysis of the purchasing power parity hypothesis (PPP). This hypothesis states that the exchange rate is equal to the ratio of the domestic price level to the foreign price level. It has recently been argued that PPP performs poorly in the 1970s. This paper examines several possible explanations for this poor performance. We examine PPP in. the l920s and the 1970s, using monthly and quarterly data, to see if the relationship has changed over time. We also examine PPP in a multi—exchange rate world, allowing a quite general error process so as to allow deviations from PpP to be autocorrelated and correlated across currencies. We are then able to examine the degree to which the world has become more interdependent. We also provide evidence that deviations from PPP may follow a random walk. Finally, the role of the U.S. dollar as base currency is examined. We find, in general, that PPP holds quite well as a long run proposition, but the deviations from PPP tend to persist. Craig S. Hakkio Department of Economics Northwestern University Evanston, Illinois 60201 (312) 492—5690