The purchasing power parity theory and the developing countries



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In this work, the Purchasing Power Parity (PPP) theory is empirically tested for a twenty year period for 12 developing countries following different exchange rate arrangements in relation to their two most important trading partners by using different models and methods of estimation. The theory tends to hold for a majority of the countries contrary to what is commonly believed regarding developing countries. It also works better for those countries having more flexible exchange rates than those following rather fixed exchange rate systems. This finding has important implications regarding the design of domestic macroeconomic policies in developing countries. When the unofficial exchange rate is used for the PPP estimation, the theory holds for those countries following fixed exchange rate systems too. This result can be utilized to evaluate the exchange rate policy of less developed countries. The evidence on the factors commonly believed to be responsible for PPP not to hold like structural change, real shocks, trade impediments, productivity bias, low substitutability between home and foreign goods, price discrimination, transport cost, differences in weights, changes in relative prices, capital movements, etc. is not conclusive but they tend to be relevant. The support for the PPP relation when unofficial exchange rates are used for those countries in the fixed exchange rate arrangements suggests that other factors help to sustain a certain official exchange rate when deviating from the PPP rate. We empirically found those factors to be, as expected, the current account balance, capital account balance, foreign exchange reserves and changes in reserves.



Purchasing power parity, Foreign exchange