Validity of Absolute Purchasing Power Parity in G7 Countries

Abstract

In popular studies, the theory of relative purchasing power parity (PPP) is tested for the real exchange rates (RERs) that are constructed by price indexes. In this paper, we construct the bilateral RERs by general price levels and study the absolute PPP theory in G7 countries. Coefficient restriction and RER misalignment distribution tests reveal that absolute PPP holds for the RERs of Canada, France, Germany, and Japan against the US in the whole samples. For the RERs of Italy and the UK against the US, we find the Balassa-Samuelson effect’s modification to the absolute PPP theory in the sub-samples.