An Alternative Version of Purchasing Power Parity

• Date: 01 October 2020
• Published date: 01 October 2020
• DOI: http://doi.org/10.1002/ijfe.1767

RESEARCH ARTICLE

An Alternative Version of Purchasing Power Parity

Dinçer Afat | Michael Frömmel

Department of Economics, Ghent

University, Belgium

Correspondence

Dr. Dinçer Afat, Department of Economics,

Ghent University. Belgium.

Email: dincer.afat@ugent.be

Abstract

A vast literature on Purchasing Power Parity (PPP) has evolved and PPP has

become the most popular concept in international finance. PPP is applied with vari-

ous price indices such as consumer price index, wholesale price index, etc. In this

article, we introduce a revised version of PPP equation for financial products,

which is strongly supported by our panel data analysis.

KEYWORDS

cross-sectional dependence, exchange rate, financial markets, panel data, purchasing power parity

JEL CLASSIFICATION

F31; G15

1|INTRODUCTION

The literature on the exchange rate is the core part of interna-

tional finance. This literature has led to various exchange

rate models; balance of payments model, purchasing power

parity, interest rate parity, monetary models, portfolio bal-

ance model, etc. Yet, those models are not very helpful in

constructing a valid empirical framework to track the move-

ments of exchange rates or to reveal a stable relationship

between the exchange rates and some particular macroeco-

nomic variables.

As Sarno and Taylor (2002, p. 136) state “… although

the theory of exchange rate determination has produced a

number of plausible models, empirical work on exchange

rates has still not produced models that are sufficiently sta-

tistically satisfactory to be considered reliable and robust.”

Consequently, the search for a better model has been going

on and this paper is an outcome of this search; an attempt to

revise the most popular exchange rate model that associates

exchange rates with price indices, Purchasing Power Parity,

by eliminating its shortcomings.

We criticize the applications of PPP that employ the price

indices, which cover tangible products, such as the consumer

price index (CPI), the wholesale price index (WPI) and etc.,

since they suffer from a number of deficiencies, which create

deviations from PPP, such as transportation cost, tariffs,

trade barriers, product differentiation and differences in price

index contents across countries. It is also naïve to ignore the

huge amount of financial speculation and expect that inter-

national trade of tangible products can determine the

exchange rates.

1

Thus, PPP should be perceived as a model

for intangible products, in other words, financial products

since deviations from PPP due to the reasons mentioned

above would be accounted when we employ intangible

products.

Our contribution to the vast literature on PPP is that we

revise the framework of PPP with respect to financial prod-

ucts. Our motivation is similar to that of Akram, Rime,

and Sarno (2009). We organize the rest of this article as

follows; first, literature outcomes are discussed in brief,

then theoretical framework of PPP and its revision are

explained. Following an empirical analysis, conclusions are

presented.

2|LITERATURE OUTCOMES

In this article, we do not provide a detailed literature survey

since numerous surveys on PPP already exist. We recom-

mend Omay, Emirmahmutoglu, and Hasanov (2018), He,

Chou, and Chang (2014), Su et al. (2014), Bahmani-

Oskooee, Chang, and Wu (2014), Beckmann (2013), Kruse,

Frömmel, Menkhoff, and Sibbertsen (2012), Chang and

Received: 18 December 2018 Revised: 16 January 2019 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1767

Int J Fin Econ. 2019;1–7. wileyonlinelibrary.com/journal/ijfe © 2019 John Wiley & Sons, Ltd. 1

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