Background

The theoretical underpinning for the study of money demand and PPP is standard. The simplest form of the PPP theory suggests that goods market arbitrage enforces parity in national price levels. Hence, converted to a common currency, national price levels should be equal.

Law of One Price

The foundation of purchasing power parity is grounded in the law of one price. The theory states that barring frictional or complicating factors such as tariffs, taxes, and transportation costs, the price of internationally traded good in one country should achieve the identical price in another country, once the price is adjusted to a common currency.

Thus, the economic theory suggests that two long-run relationships could be found: one between domestic prices, foreign prices, and the nominal exchange rate; and another between domestic prices, money, real income, and the nominal interest rate. While we would expect both the real exchange rate and real money demand to be fairly stable in the long run, we would also expect temporary deviations from these two long-run equilibrium to affect future fluctuations in the variables such that the long-run equilibrium are restored.

This transformation, as well as some important economic structural reforms, could have arguably affected both the long-run money demand relationship and the real exchange rate, since it led to both some financial deepening (as low-income households gained access to formal banking services to a larger extent), as well as a strong increase in foreign competition, which in turn could have had a one-off effect on the domestic price level.

Conceptually, the PPP’s are very similar to consumer price indexes. The PPP’s are measures of price level differences across space or, in their most popular form, across countries. Because the prices of goods and services in different countries are expressed in national currencies, the purchasing power parity between currencies of two countries, say A and B, is the number of units of currency of country B (or A) that has the same purchasing power as one unit of currency of country A (or B). Though the PPP’s are similar to price index numbers in spatial comparisons, they assume special significance because the PPP’s can be used as a conversion factor, in place of exchange rates, in converting various economic aggregates from different countries into a common currency unit. The converted aggregates are expressed in a common currency unit, and the aggregates are considered to be real value aggregates devoid of price variations among countries. These real aggregates make it feasible to undertake cross-country comparisons and to undertake economic and statistical analyses on global and regional levels.

The purchasing power of different currencies is equalized for a given basket of goods. In the “relative” version, the difference in the rate of change in prices at home and abroad – the difference in the inflation rates – is equal to the percentage depreciation or appreciation of the exchange rate.