The PPP theory has been deemed to have a reservation for the exchange rates depreciation or appreciation as well as the rate of inflation change. It is in this reservation that PPP is found to be in favor of long- term exchange rates model as opposed to the short term due to the volatility of the inflation rate that influences the exchange rate both significantly and insignificantly. A perfect example is the PPP relationship between the American dollar and Canadian dollar between the period spanning 1950 to 1986. This study came to a major conclusion that the deviations that existed from the PPP relationship in comparing the purchasing power between these two currencies at their given exchange rate at the time, were consistently significant in elaborating on the changes in the domestic prices in a fixed exchange rate or a flexible one
PPP generally provides a guiding tool for the economists and financial analysts to predict the changing levels of exchange rates. This is despite the fact that PPP holds under the condition that the exchange rate is consistent for a long period of time. This leaves the specialists to question whether or not the PPP theory suggests a true fact, and whether it leaves the exchange rate being under- valued or over- valued. Time series data has proposed a series of tests that tend to provide whether the PPP relationship holds in the short- run, but nothing conclusive has yet been established, what is left is speculation on its effect and its reservations in the long- run effects on exchange rates. What might affect the PPP in the short run is the nominal shocks on currencies of given countries might undergo thus leaving the PPP theory hanging in the balance as these shocks may have dire effect on the exchange rate, therefore conclusively stating that PPP may not hold in the short run due to such conditions.
Bibliography
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