Empirical Evidence on the (Relative) Purchasing Power Parity (PPP)
The PPP implies a long-run relationship between the changes in the exchange rate and inflation rate differential between two countries. The idea is that these variables should move together in the same direction. Generally, the evidence for the PPP isn’t overwhelming because the empirical verification of the PPP seems to be sensitive to the choice of the base period and the size of the inflation differential between two countries.
For example, everything else constant, a larger inflation differential seems to be helpful in verifying the PPP. This is because variation in inflation is necessary for inflation to be a helpful predictor. With low inflation that varies little, the forces assumed to be important in PPP are overwhelmed by tariff changes, changes in transportation costs and other real factors.
Other obstacles to finding empirical support for the PPP exist. These obstacles weaken the connection between the prices of similar goods in different countries, making it difficult for the PPP to hold. Some of these barriers are nontradable goods, government control of prices, restrictions on international trade, and transportation costs.
Some goods and services are called nontradables because their transportation costs are prohibitively high (housing and haircuts, for example). Prices of nontraded goods and services aren’t linked among countries because domestic market conditions solely determine their prices. When the domestic market conditions change, prices of nontraded goods change.
However, these changes in prices may not reflect the changes in the price of a similar nontraded good in other countries. This situation leads to deviations from the PPP.
Even if a good is tradable, a large increase in its transportation cost or the introduction of a government restriction on its trade in the form of tariffs, quotas, and so on increase the price of this good and, therefore, limit its trade.
For example, in November 2012, the U.S. International Trade Commission decided to impose a tariff between 24 and 36 percent on Chinese-made solar panels. The reason was the government provided subsidy to solar panel production in China, which was believed to have provided an unfair advantage to Chinese suppliers.
Any type of trade impediment as in this example weakens the relationship between changes in the exchange rate and inflation differential, which also leads to deviations from the PPP.