This Paper discuss about the Validity of the Purchasing Power Parity around the world. Therefore in order to test the validity of the Purchasing Power Parity (PPP), I have decided to take to two countries and have carried out some empirical tests to test the applicability of PPP. I have taken and tested the PPP between India and United Kingdom (UK) where one being domestic and another being foreign country respectively. As we have seen Indian Economy is growing in an accelerating pace where as IMF economic outlook (2010) believes advance economy countries will face challenges (which is true if we look at the European economy in the last 2years) some factors liable are due to the uncertainty of the financial sector, increased in funding cost, consumers and businesses lower confidence reducing the private consumption and investment. On the other hand, IMF believes India’s economy growing at an accelerating pace and is highly likely to raise more near future. One of the main reasons is because of their domestic demand of their goods all over their country and so as the demand has increased all over the world which leads to increase in their exports and eventually results in economic growth. As we can see the from the recent IMF update 2010, the emerging and developing countries tends to perform better than the advanced economies where we can take UK as a best example. [1]

Therefore in my opinion I thought it would be interesting idea to select 2 countries, India and UK, one being developing country and another being developed countries respectively.

A very important point which need to noted that, in the foreign exchange rate market the India’s central bank intervenes in order to stabilise the movements in the exchange rate, therefore what we can say the exchange rate is not only determined inflation differential between both the countries.

In addition India have got some specific factors which determine the exchange rate, some of the key factors specific to India has been discussed later in the paper.

2. Theoretical framework:-

The term Purchasing Power Parity is a very simple and easy to understand theory that strives to explain the changes in exchange rates of different countries in an extended time period. It was first stated by Cassel in 1918 and is coming to the forefront at an accelerating pace due to global progression. Ideas of PPP have been discussed before as well by scholars from the 15th and 16th centuries such as Officer (1982).

Many argue that PPP is not a valid model as it does not take many important factors into consideration and it does not hold true when observing exchange rates on a short time period however long run period tends to hold. Should it be considered as a random walk phenomenon? Previous studies have shown that shocks to the real exchange rate dwindle out very slowly. There is also a proof showing that fast developing countries usually experience real exchange rate appreciations while richer countries it tends to be higher. The “Balassa Samuelson” theory is very well known within the framework of PPP. Yet in industrializing countries, the results of the examination of empirical evidence in favour of Balassa Samuelson are weak.

Frankel (1986, 1990) argued that the reason for failure to reject the random walk model of real exchange rates was a lack of power.

In order to understand PPP we must take in to account the concept of law of one price as PPP is the application of the law. The law of one price states that in a competitive market excluding transaction cost and barriers to trade, identical goods in 2 countries should sell for the same price at the same time, when expressed in the same currency. The law of one price implies that the dollar price of good i is the same wherever it is sold.

PiUS =(E$/€)(PiE) (1)

Equivalently,

E$/€ = PiUS/PE

Thus the exchage rate amongst 2 countries’ currencies is equal to the ratios of the countrys’ price level. This means that if there is a decline in the domestic purchasing power of a currency, it will cause a proportional currency depreciation in the foreign exchange market. This shows that PPP claims that when measured in the same currency, the price levels of all countries will be the same.

An easy way to understand the law of one price is to consider a practical example. if the dollar/pound exchange rate is $1.60 per pound a cell phone costing $100 in New York must not sell for more than £62.5 (Pus/ (E$/€) ) in United Kingdom. So in dollars the cell phone sold in London is $1.60 × £62.5 = $100. If there is any deviation from this price, then there would be an arbitrage opportunity.

Absolute and Relative PPP

The absolute PPP exchange rate considers the