__________________________________________________________
THE AUSTRALIAN NATIONAL UNIVERSITY
School of Finance and Applied Statistics
Research Project in International Finance

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DANG H. PHAM
U4278723
Research Project in International Finance: 2007 Dang H. Pham
1. PPP with 12 countries.......................................................................................... 15
2. Effect of trading and FDI on PPP ....................................................................... 20
VI. CONCLUSION ........................................................................................ 22
VII. FUTURE RESEARCH DIRECTIONS..................................................... 23 3

Research Project in International Finance: 2007 Dang H. Pham
I. INTRODUCTION
The interrelations between three major components of the international market
(international trade, foreign exchange and capital market) are explained by the
economic theories called the international parity conditions. It is considered to be
unique to the field of International Finance (Eiteman, Stonehill and Moffett
2006:102). Deriving from the Law of one price, the absolute form of purchasing
power parity (PPP) states that if the market is frictionless the price of identical
products and services should be the same in different markets. For instance, if the
price of the product in Australian dollar is P
AUD
, then the price of the identical
product in U.S. dollar (P
USD
) should be equal to P
AUD

United States and Thailand in 2005, with Singapore in 2003 and with New Zealand
from 1993. It is now in negotiating Free Trade Agreements with other countries and
areas such as Japan, ASEAN, Malaysia, China, Chile and Gulf countries. This
research project tests the PPP between Australia and its trading partners over the
period from 1984 to 2006 and provides some insights on particular effects that the
level of bilateral trade and investment have on their PPP . Using quarterly of foreign
exchange rates and proxy for country price level (both consumer price index and
producer/whole sales price index) evidence from my sample shows that PPP holds for
4

Research Project in International Finance: 2007 Dang H. Pham
some countries while it does not hold for others. Further, the higher level of bilateral
trade significantly and positively associates with the higher level of PPP . Foreign
investment level is found to have positive impacts on PPP but not significantly.
This research is outlined as follows: Part II reviews PPP literature, in which the
subsection 1 on PPP theoretical background highlights the law of one price and the
role of international trade as crucial conditions for the existence of the parity
condition. An overall picture about extant empirical literatures on PPP including
Australian evidences is provided in subsection 2 and 3. From these reviews we
develop our arguments about the impacts of trade and investment on the PPP s
between Australia and its trading partners. Part III presents the hypothesis our
research and the methodologies, models we use to test the hypothesis in details. Part
IV describes and discuss about the data used in our research. The results of this
research are reported and discussed in Part V. Conclusion is provided in Part VI; and
Part VII proposes some direction for future research.
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Research Project in International Finance: 2007 Dang H. Pham
II. LITERATURE REVIEW
1. Theoretical background

+
+
=
(1.1) or (1.2)
fh
fh
S
ππ
−=Δ
/
Where: is the expected spot exchange rate at time t, is the current spot
exchange rate,
)(
/ fh
t
SE
fh
S
/
0
h
π
is the inflation rate in home country and
f
π
is the inflation rate in
foreign country. is the change in spot exchange rate in a period of time t.
fh
S
/

employed; (iii) purely traded goods’ prices or non-traded as well as traded goods
prices are considered; (iv) bilateral or multilateral approach is adopted; and (v) the
short run or the long run is investigated (Rush and Husted, 1985). In the respect of
long-run or short-run validity of PPP, for example, evidence from Edler and Lehmann
(1983), Enders (1988) and Ardeni and Lubian (1991) reject long-run PPP. However,
Diebold, Husted and Rush (1991), Cheung and Lai (1993), Edison (1987), Frenkel
(1981), Branson (1981), Desai (1981), and Miller (1986) strongly support that the
PPP holds in the long run and poorly in the short-run. Cooper (1994) claims that the
main reasons for the inconclusive results are due to the difference in particular
currencies under consideration, the price indices used to measure price levels of
inflation, and the method of analysis employed.
Early empirical tests (mainly in the 1970s) find support for the long-run and
continuous PPP (Frankel, 1976 and1981). This might be partly due to the data of a
period of stable exchange rates (few years post-float after 1971- collapse of the
Bretton Woods Agreement). On the other hand, PPP deviates significantly from
equilibrium in the short-run PPP due to the sticky nominal prices (Dornbusch, 1976).
However, there is no evidence of how far do exchange rates deviate from the mean
and how fast they revert to the mean, knowing that mean reversion of exchange rates
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Research Project in International Finance: 2007 Dang H. Pham
toward its mean is the key characteristic and necessary condition for long-run PPP to
hold (Taylor and Taylor, 2004). Studies employing unit root test of real exchange rate
(the null hypothesis is that real exchange rate follow a random walk) could not reject
the random walk (see, for example, Roll 1979);
Contemporary empirical studies of PPP are dominated by unit root tests with more
advanced techniques. Frankel ( 1986) tests the first order autocorrelation model for
the real exchange rates:
tt
eeee

that the deviation from PPP real exchange rate has half-life of 3 to 5 years.
While some recent studies use non-linear dynamic models that allow for the
autoregressive coefficients to vary find supportive evidence of non-linear long-run
PPP. For example, Taylor, Peel and Sarno (2001) find support for non-linear mean-
reverting real exchange rates. They also find that ‘modest’ deviation of less than 5%
have half-life of less than 3 years while deviations greater than 5% have even shorter
half-life. Sarno and Valente (2006) test long-run PPP using complex non-linear
model. Their results indicate that long-run PPP does appear to hold. Further, PPP
deviations revert more quickly under floating exchange regimes. In contrast, other
latest studies on the validity of PPP even using advanced techniques still have
different results. For example, Alba and Papell (2007) examines the long-run PPP
using panel data methods to test for unit roots in the USD real exchange rates of 84
countries finds that PPP holds for European and Latin American countries but not for
Asian and African countries. Arghyrou and Gregoriou (2007) tests for long-run PPP
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Research Project in International Finance: 2007 Dang H. Pham
using more sophisticated unit root test on G7 countries over the last 30 years. They
find that PPP does not hold in the long-run.
In general, PPP test appear to be a puzzle. The extremely high short-term volatility of
exchange rates hardly reconcile with the long-run PPP and the half-life of PPP
reversion of 3 to 5 years is too long to be caused by short-run sticky nominal prices
(Rogoff, 1996) states,. Perhaps the international goods market is not as integrated as
we think, with large trading frictions creating a ‘band of inaction’ that permits wild
fluctuation in nominal exchange rate with no effect on price levels (Rogoff, 1996;
Taylor and Taylor, 2004). Alba and Papell (2007) share the same view when they find
evidence that PPP is stronger in countries that have higher levels of trade, closer to
the US (physical distance), and countries characteristics affect PPP adherence. Based
on these finding, when testing PPP between Australia and its trading partners, this
paper hypothesizes that PPP hold better between Australia and its major trading