The evience suggests that PPP hold both in the short and long run - Essay Example

an be substantial short-run deviations from PPP, but in the long run relative PPP holds remarkably well because fundamentals and arbitrage are dominant long-run economic forces” (Marewijk, chapter 20); In short run price level tends to be sticky and takes time to change (Rogoff, 1996). And that “Dorodian, Jung, and Boyd [1999] found that in the long-run, PPP tends to hold more often under a floating exchange rate regime than under a fixed exchange rate system” (Anorou, Braha & Ahmad, 2002).

There is however some studies which focused on the short run basis of PPP. Chowdhry, Roll & Xia (2004) find that “relative PPP holds well in the short run in both single-country-pair OLS regressions and a pooled system regression” and that their evidence “for short-run relative PPP is unlikely to be driven by missing world factors or by real effects of inflation”. Further, “our results complement the findings from the long-run PPP tests, and help resolve the PPP puzzle in the short run”.

They also have an evidence that “relative purchasing power parity holds quite well in the short run when inflation is extracted from stock prices”. “For small differences in annual inflation between the United States and the country concerned, the correlation between relative inflation and depreciation in each of the years seems low. Relative PPP appears to “hold more closely for countries experiencing relatively high inflation” (Taylor & Taylor, 2004); “Finally, the IIRE is operative in both the short and long run in response to changes in the domestic price level” (Elwood & Fields, 1998).

Based on those results, Click (1996), as mentioned by Fujiki & Kitamura in 2004 concludes that in “the time-series dimension, using the random-effects model, purchasing power parity holds, conditional upon the Balassa–Samuelson effect.” Chapter 18 — Exchange Rate Theories discusses the favorable effect of PPP in the short run over long run. “PPP holds even in the