Purchasing Power Parity and Cointegration

Purchasing power parity (PPP) as a theory of exchange rate determination implies that exchange rate movements are determined by changes of the relative prices between two countries. Absolute purchasing power parity is based on the ‘law of one price’, i.e. the price of one good is the same in two different countries, when denominated in the same currency. Under a number of restrictive assumptions such as perfect competition and substitution on world markets, no transaction costs and aggregated price indices having the same construction and weights, the law of one price does not only hold for a single good but also for aggregated price indices.