Purchasing power parity: Basics of Evaluating PPP
Arguably, the PPP is the most intensely examined parity condition in international economics. Constrained by data limita- tions, empirical studies usually examine the validity of relative instead of absolute PPP. Specifically, price indexes do not allow an easy comparison of absolute price levels across countries.
The choice of price indexes is an issue in evaluating PPP.The common choice is between consumer price and producer (wholesale) price indexes. Some researchers use the former index as a proxy for the price indexofnontradable goods andthe latterone as a proxy for tradable goods. In general, the use of producer price index yields stronger evidence in favor of PPP than the use of consumer price index does. Other candidates include price indexes of imports and exports, the GDP deflator, and components of the GDP deflator.
The sample period used in PPP studies ranges from the post-1973 floating period to historical samples that cover 100 years or more. There is a trade-off between short and long samples. An advantage of long historical samples is that they are better suited for studying long-term trends and thus for evaluating the long-run PPP. A drawback, however, is that these samples cover periods of different exchange regime arrangements and significant economic changes that may complicate the analysis. Compared with long historical samples, the post- 1973 period may not have enough observations to reveal reversion to thePPP.Nonetheless, results from the post-1973 period are derived from a more homogenous setting and are likely to be more relevant for current policy considerations.