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# 6.4 Techniques of Testing PPP Theory in Economic-History Literature

## 6.4.1 Comparative-Static Computation

Let E0 denote E in period 0. An obvious test of PPP theory is to measure P and P* as index numbers with value unity in base period 0 and compute V = (P/P*)E0 for either one period, a few discontinuous periods or a continuous sequence of periods. The computed V are then compared with the corresponding values of E, in a table or graph. Alternatively, (E/E0)/(P/P*) is compared with unity. In either case, the closer the computed value to the norm, PPP-predicted, value, the closer is PPP theory to fulfillment. Any noticeable divergences are then explained in terms of non-PPP influences on the exchange rate (augmented PPP theory). One can allow for a lagged effect of R on E. Further, investigations of lead-lag relationships are used to test the PPP-postulated direction of causality, from prices to the exchange rate. This entire approach has the advantage of lying outside formal statistical analysis.

## 6.4.2 Regression Analysis

The use of regression analysis was a natural development in testing PPP theory. For example (using lower-case letters to denote logarithms), e is regressed on P and p* or on r−1; q is regressed on a constant. Properties such as symmetry and proportionality can be readily tested in terms of elasticities.

## 6.4.3 Testing for Causality

The PPP relationship tested can either be an equilibrium relationship or a causal relationship, each being tested directly. A hybrid ...

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