An Empirical Analysis of Purchasing Power Parity: A Case Study of Two Anglophone Ecowas Members

An Empirical Analysis of Purchasing Power Parity: A Case Study of Two Anglophone Ecowas Members

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1.1: Background Information

One of the most provocatively debated issues in international macroeconomics literature pertains to whether or not Purchasing Power Parity (PPP) holds across borders. The doctrine of PPP in its various forms states that a common basket of goods, when quoted in the same currency, costs the same in all countries. As such, the theory represents an application of the 'Law of One Price' (LOOP). This law states that in the presence of competitive market structure and the absence of transport cost and other barriers to trade, identical products which are sold in different countries will sell at the same price when expressed in terms of a common currency (Pilbeam, 1992). The parity condition rests on the assumption of perfect inter-country commodity arbitrage and is the central building block of many theoretical and empirical models of exchange rate determination. However, the implication of this theory is that a country with inflation

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higher than that of her trading partner(s) will tend to have a depreciating currency.

It is known a 'priori' that PPP is an exact relationship and it holds under certain circumstances. Although earlier studies, like Froot and Rogoff (1995) had reported

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evidence of short run violations, many economists like McDonald (1996), Wu (1996) and others still hold the view that over the long run, relative prices may move in proportion to the nominal exchange rate so that real exchange rate will exhibit mean reversion. Hence, the imperativeness of testing PPP for long run relationship.

Therefore, this study which broadly aim at comparing the purchasing powers of the currencies of two West AErican neighbours namely Nigeria and Ghana, will

bilaterally test the long-run validity or otherwise of the PPP doctrine individually for each of the countries. The world number one with respect to the values of all categories of GDP (IMF database, 2005) remains the numeraire country. However, for comparison purpose, it is worth highlighting some striking and relevant features of the two ECOWAS members included in the study.

The first feature is that both countries rely on exportation of primary products for foreign exchange earnings. The products are agricultural such as Cocoa in the case of Ghana and Crude Oil in the case of Nigeria. Secondly, they are basically price takers in international export markets. Due to weak manufacturing base, these countries depend on imported manufactured goods from industrialized countries. They are also price takers in the import markets. The third feature is that intercountry trade between the two countries like every other Afi.ican country is small. This is sequel to poor infrastructures and high transaction cost. It is of interest to note that Nigeria and Ghana had different exchange rate regimes overtime, although the current trend is that they are adopting more flexible regimes (Nagayasu, 1998). Finally, in line with 2005 GDP data,

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the IMF ranked Nigeria fourth in Africa and forty-seventh in the world while Ghana was ranked tenth in Africa and seventy-fifth in the world. In the light of these particular attributes of these countries, it is not { investigate the extent to which the changes in the nominal exchange rate of each are affected by her output's price level relative to that of her trading partner (USA).

According to literature, PPP is more likely to hold among countries with similar consumption patterns and the same inflation trend. Generally PPP has been found to hold in high inflation countries (Rogoff, 1996). However, this study aims at testing the

validity of PPP theory for the aforementioned West African Countries, and finally comparing the economies of both countries with respect to the purchasing power of their currencies.

1.2: Statement of the Problem

A problem that has challenged economists comparing economies across national boundaries is that variables such as Gross Domestic Product (GDP) of countries are expressed in their respective national currencies. Imagine you are planning a trip to France and would like to figure out how much currency you will need during your visit. You would need to know how much in French francs it would cost for incidentals such as meals, sightseeing, and souvenirs. What information would be helpfbl to you in making your estimate? You could check the price of, say, a lunch in your hometown and then convert that figure into fiancs using the exchange rate. This type of estimate would not be very accurate, however, because it is likely that a lunch in your hometown costs relatively more or less than a lunch in France. A better estimate

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would be based on the price of a lunch in France (Vachris and Thomas, 1999). Similarly, if you were opening a subsidiary company in Ghana, how would you determine the salaries for your employees? Again, using the exchange rate to convert

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the salary you would pay in Nigeria into cedes would not be accurate. To adequately compensate employees crossing the boarder, you would need information about the cost of living in Ghana. Finally, if a government or international organization were comparing national expenditures across different countries, merely collecting the gross domestic products (GDPs) of the countries and using exchange rates to convert them into a single currency would not yield an accurate comparison. Again, the comparison

based on exchange rates does not take into account differing prices among the countries. In each of these scenarios, analysts could construct better estimates if they convert the data into a common currency and value it at the same price levels. While exchange rates can be used for this comparison, analysts find it to be deficient because of the effects of non-traded goods and services, capital movements, and exchange market interventions. However, this requires that national levels of GDP be converted into a common currency before the comparison can be made.

The long-standing recognition of these deficiencies led to the development of

PPP    as a more appropriate currency converter to compare GDP and its components across countries. Because exchange rate movements, in general tend to be more volatile than changes in national price levels, the PPP approach provides the proper basis for comparing living standards and examining productivity levels overtime. The relationship between the Euro and US dollars provides a good example. In 2002, it took US$.91 to purchase a Euro, while in 2004 it took US$1.21. This has occurred during a

period when both regions experienced low rates of inflation and moderate growth rates.

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This means roughly that a E m country had an exchange rate converted GDP relative to the US. that was much higher in 2004 than in 2002. Clearly the use of exchange rates gets both the level and changes of the profluctive.. capacity of countries wrong (Vachris, 1993).

If a Big Mac with medium drink in the Philippines, for example costs 107 Poses in July 2004 compared to $3.99 in the USA, the ratio of the prices in poses divided by the US price is the basic example of PPP between the Philippines and the USA. The ratio, 26.8 imply that 26.8 poses have the same purchasing power as one US.

dollar. To compare the Philippine's economy with that of the US, using the PPP based

on the Big Mac index, the Philippine's  GDP would be higher than its value when

exchange rate is used. In reality, Purchasing Power Parities are prepared using relative prices for a very large number of comparable goods and services because the levels of price differences differ between different items and parts of the globe. This is another reason why PPPs should be used instead of exchange rates for. comparison purposes (Vogel, 2005).

The pervasiveness of PPP in macroeconomics has gone hand in hand with the literature on the empirical tests of the theory. Most of these tests have been done for developed countries of Europe, Asia and America. Very few such studies have been done in less developed countries of Africa in general and ECOWAS sub-region in particular.

Consequently, this research is an attempt at testing the validity of the PPP theory for the above-mentioned neighboring Anglophone West African Nations. It will also compare the economies of both countries with respect to the purchasing power of their

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currencies. Table 1.1 shows some selected African countries and their GDP based on nominal exchange rates and PPP exchange rates.


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