Purchasing Power Parity and Exchange Rate Management Under Managed Float: Case for INR or USD

Abstract

Purchasing Power Parity (PPP) doctrine has been a significant topic in the domain of international finance and economics. Several studies have been conducted on the issue of testing the soundness of the PPP hypothesis but a very few studies have been done for developing nations, particularly for India. This study tried to empirically test the PPP hypothesis for Indian rupee/US dollar (INR/USD) rate using quarterly data for the period 2001:1 – 2024:2. The stationarity of the relevant variables is examined by using the econometric tool of Augmented Dickey Fuller (ADF) and Phillip - Perron (PP) tests. To confirm empirical validity of PPP hypothesis, OLS regression technique is used. Autocorrelation problem is removed with the help of AR1 (Cochrane-Orcutt) and maximum likelihood procedures. The PPP model is estimated in naïve static form as well as the partial adjustment framework. The partial adjustment framework helps to find out the speed with which the actual exchange rate moves towards and reaches its equilibrium level. The empirical findings show that absolute PPP does not work well in its naïve static form, but it works well in partial adjustment framework with 2.5 quarters being speed of adjustment. The relative PPP is found to work well in both frameworks with 1.5 quarters as speed of adjustment. Thus, the policymakers may use the PPP hypothesis for exchange rate forecasting. Also, it is suggested that the policymakers should carefully consider the effect of internal or external shocks on PPP and tailor their monetary policy measures accordingly.

Keywords: Purchasing Power Parity, Exchange Rate, Relative Prices, Regression, ADF Test, Unit Root, Stationarity

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