The theory of purchasing power parity attempts to explain changes in an exchange rate in terms of differences in international competitiveness. It argues that an exchange rate will adjust to remove inflation differentials and ensure that no country has a competitive advantage over its trading partners. This thesis hopes to examine the applicability of this theory to the long run determination of the value of the Australian exchange rate vis-a-vis some of its major trading partners. The thesis will then attempt to model the short run dynamics of the exchange rate as it moves to its long run equilibrium.
A review of the theories of exchange rate determination is presented which will include a discussion of the theory of purchasing power parity along with the elasticity, monetary, and portfolio balance approaches to exchange rate determination. Previous empirical work done on the existence of purchasing power parity in Australia,
the United States, and Europe, for the long and short runs will be surveyed. The time series technique of cointegration will be used to examine for long run purchasing power parity for both the pre-float and post-float periods, between Australia and the United States, Germany, Japan, the United Kingdom, New Zealand, and Switzerland. For those exchange rates found to be cointegrated, their short run dynamics will then be modelled using an error correction mechanism in order to determine the behaviour of the Australian exchange rate as it moves toward its long run equilibrium.
The empirical results suggest that there is a long run purchasing power parity influence upon the value of the Australian dollar against the United States dollar, the Deutschmark, and the Pound Sterling, while between the Australian dollar and the Yen and the Swiss franc, there is a long run relationship which cannot be characterised by purchasing power parity. Deviations from this long
run equilibrium however, can be protracted in the short run, with the equilibrium not being reached for at least eighteen months. The modelling also showed that the value of the Australian dollar was influenced in the short run by the automatic correction of past deviations, past price ratios, and annual changes in the exchange rate.