Long-term relationship between prices and exchange rates

Abstract

Purpose: This paper aimed to prove the existence of a long-term relationship between prices and exchange rates like that derived from the theory of purchasing power parity. Particular attention has been paid to the possible reasons behind the deviations of exchange rates from the values implied by the parity and to the theoretical justification of this phenomenon. Design/Methodology/Approach: The research was carried out by detailed analysing of the exchange rates of major currencies of the world, the U.S. dollar, the British pound and the Japanese yen related to individual quarters in the 40 years period. The formal empirical verification was made with the use of econometric tools that allow a long-term study of the relationship between stochastic processes. In analyses there were used the OLS estimator and the appropriate regression of USD/JPY/GBP relative to the logarithms of price levels in these countries. The phenomena of the cointegration of rates and prices and the stationarity of real exchange rates were also examined. Findings: Formal verification did not allow the confirmation of the exact relationship of long-term forecast by purchasing power parity. For all the examined exchange rates, the existence of co-integrating relationship was not shown, the relationship which would be fulfilled in spite of short-term deviations from parity. Despite the fact that the study employed data concerning a forty-year time period, the cycles of deviations from the balance path take too long to be able to demonstrate the stationarity of residuals in the cointegration analysis. This hypothetically makes purchasing power parity a very long-term relationship, which in the short-term and medium-term is subject to relatively strong disturbance. Practical implications: This paper analyses and empirically verifies the widely known long-term relationship of purchasing power parity. Moreover, it comes up with the proper economic justification of the results. Originality/Value: The purchasing power parity theory tends to be used by institutions actively creating macroeconomic policies. The research findings may contribute for better understanding of monetary policies in environment of inflation.