The Law of One Price and the Purchase Power Parity theory: a review

Abstract

Purchasing Power Parity (PPP) is a theory according to which the price of a same basket of goods in different countries expressed in a common currency should be equalized, at least in the long run and in the absence of transportation costs and other frictions. This theory is used to make predictions on what the value of the nominal exchange rate should be in the future (equal to the ratio of price levels), thus allowing to estimate by how much a currency is currently under- or over-valued, and to make a prediction on the currency’ future appreciation or depreciation. Another implication of the PPP theory is the following: if converted in a foreign currency at the nominal exchange rate calculated according to the PPP, a unit of the domestic currency should have the same purchasing power in the foreign country. The nominal exchange rates implied by PPP then can be used to convert the real GDP of different countries in a common currency (for example, the U.S. dollar), making the standard of living of these countries comparable. The objective of this thesis is to present a review of the studies that empirically test whether this theory matches the reality