Examining the Real Implications of the Purchasing Power Parity

This study focuses on the purchasing power between the dollar and the yuan and its usefulness in forecasting changes in exchange rates in the long run. In particular, PPP theory helps to clarify the inclination of countries with high inflation to incur a depreciation of their exchange rates. The theoretical part highlights the deviations from theory, its causes and its interconnections with other theories that analyse the relationship between exchange rates and other macroeconomic variables. Then, the validity of the theory for the USD / JPY exchange rate is examined from 1980 to 2013. The test found proof in support of the theory at 1% confidence level. Substantial emphasis is given on the effects of the asset price bubble in Japan during 1986 - 1992 and the US economic crisis of 2008 and more specifically on the behaviour of the parity during such a period of increased uncertainty.