Purchasing Power Parities for the DM

Abstract

The Purchasing Power Theory with Relation to the D-Mark

The purchasing power theory represents one of the probably oldest theoretical components in determining long-term exchange-rate equilibrium. It forms part also of the most recent approaches to the determination of exchange rates as an important equilibrium condition and has thus hardly lost in relevance over time. The present paper analyzes this approach to equilibrium on the basis of the theory of co-integrated processes with regard to its empirical evidence. The introductory (part I and II) throws some light on the exchange rate credo of the last few decades and briefly presents the main characteristics of the theoretical concept underlying the purchasing power parity theory. Moreover, the paper deals with a number of problems involved in such empirical model-building and/or revision.

Part III contains an introductory to the theory of co-integrated time series as developed by Engle and Granger, among others, for reviewing long-term equilibrium relations. Part IV presents and discussed the empirical results of 14 DM-related bilateral exchange rates with a number of important industrialized countries in the period from 1974 to 1987. The results of the co-integration assessment speak in favour of the validity of the purchasing power parity theory in 50% of the cases. It may be interesting in this context that the hypothesis of long-term equilibrium relations within the meaning of the purchasing power parity theory had to be rejected also for the DM/FF rate – with France being Germany's most important partner in the EMS – besides the DM/US-$ and the DM/yen rates enjoying real freedom of float.