Analysing The Dollar And Pound Exchange Rate Finance Essay
Purchasing power parity (PPP) states that in the absence of transaction costs and barriers to trade, the nominal exchange rate between two countries should equate the aggregate price levels of the respective countries. Since its formal introduction in 1918 by Gustav Cassel as a means of stabilising the exchange rates of the major countries after WW1, PPP theory has been extensively scrutinised and investigated by researchers to determine its relevance as a practical theory in exchange rate determination. Starting with the testing of the most basic relationship of PPP in the 1970s till the recent use of more advanced econometric techniques like Co-integration or Fractional Integration, the results gathered from the numerous literature have not been consistent. But even with the mixed results, there was always belief by academia or interested parties that the PPP holds the potential to be the cornerstone for the determination of exchange rates. As a result this paper attempts to join the plentiful literature on PPP, by investigating the convergence of long run PPP for two of most advanced economies in the world, United States of America and United Kingdom respectively. Co-integration and Johansen test have been correspondingly employed to the data set that spans from 1968 to 2010. The findings from both tests were contrasting where Co-integration advocating that PPP does not hold in the long run while Johansen Co-integration test shows the existence of one co-integrating relationship. Nevertheless, this result is consistent with existing literature where different econometric models have produced different results, even on similar dataset.