An evaluation of purchasing power parity and the monetary model as explanations of rand exchange rate behaviour

M.Com. (Economics)This dissertation offers an evaluation of the performance of purchasing power parity (PPP) and the monetary approach as explanations of rand exchange rate behaviour over the last three decades. The theory of purchasing power parity is examined in detail. Thereafter purchasing power parity is combined with the quantity theory of money placing the theory in the broader context of the monetary approach. A modified monetary model illustrating exchange rate overshooting in the short-run and adjustment to PPP in the long-run is then examined in some detail. Chapter 4 presents an overview of the: empirical evidence on PPP and the monetary approach from industrialized countries and developing nations. Results are generally mixed but there does appear to be some strong support for PPP holding in the (very) long run in the case of the currencies of industrialized countries. However, it has proven very difficult to reconcile the persistence of deviations from PPP over the short to medium term with the theory of long-run purchasing power parity. This is known as, the purchasing power parity puzzle and is particularly evident for floating exchange rate regimes of industrialized countries. Studies of developing nation currencies are less supportive of PPP. However, much more research needs to be done before any firm conclusions can be made regarding exchange rate behaviour in developing countries..