DP4495 The Purchasing Power Parity Debate

Author(s): Mark P Taylor , Alan M. Taylor

Publication Date: July 2004

Keyword(s): purchasing power parity , exchange rates , real exchange rates , nonlinearity , long-run equilibrium

JEL(s): F31 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4495.asp

Originally propounded by the 16th-century scholars of the University of Salamanca, the concept of purchasing power parity (PPP) was revived in the interwar period in the context of the debate concerning the appropriate level at which to re-establish international exchange rate parities. Broadly accepted as a long-run equilibrium condition in the post-war period, it first was advocated as a short-run equilibrium by many international economists in the first few years following the breakdown of the Bretton Woods system in the early 1970s and then increasingly came under attack on both theoretical and empirical grounds from the late 1970s to the mid 1990s. Accordingly, over the last three decades, a large literature has built up that examines how much the data deviated from theory, and the fruits of this research have provided a deeper understanding of how well PPP applies in both the short run and the long run. Since the mid 1990s, larger datasets and nonlinear econometric methods, in particular, have improved estimation. As deviations narrowed between real exchange rates and PPP, so did the gap narrow between theory and data, and some degree of confidence in long-run PPP began to emerge again. In this respect, the idea of long-run PPP now enjoys perhaps its strongest support in more than 30 years, a distinct reversion in economic thought.