Short-Run Deviations From Purchasing Power Parity (PPP): A Case Of Expectational Changes

Abstract

The theory of purchasing power parity was originally designed by Gustav Cassel in 1918 to make the simplified guess of two currencies’ exchange rate levels. The theory had a simple but convincing argument that the exchange rates tend to gravitate toward the ratio of purchasing powers of two currencies. However, the actual exchange rates can deviate from these expected values of purchasing power ratios. Recognizing the difference between nominal and real exchange rates, economic theoreticians have tried to comprise these deviations from the actual exchange rates and those expected to by the PPP theory. In this paper we hypothesize another explanation for deviations of exchange rates form those values that are expected by the PPP theory. When tested for the selected currencies, our explanation is suitable enough to maintain that the expected PPP for the U.S. and Canadian dollar rates and the U.S. dollar and German mark rate.