ABSTRACT
The relationship between exchange rates and prices that is depicted by the purchasing power parity (PPP) hypothesis is one of the oldest and the most controversial in the theory of exchange rate determination. The hypothesis in its ‘absolute version’ states that the exchange rate (the domestic currency cost of a unit of foreign currency) equals the ratio of domestic to foreign prices. The ‘relative version’ of the hypothesis states that the change in the rate is equal to the inflation differential. Historically, the hypothesis has been subjected to varied interpretations. Some authors have held that PPP provides a basis for the determination of exchange rates with useful policy implications. Others have argued that PPP is an equilibrium relationship that leaves much to be explained. On an empirical level, many authors have found that PPP does not appear to hold very well, particularly over recent times since the return to flexible exchange rates among major currencies in the early 1970s.
