Purchasing Power Parity Theory: The Test And Its Use

The issue of exchange rate is the core issue of international integration of Chinese finance, and the purchasing power parity (PPP) theory is the basis of the exchange rate issue. As the fundamental exchange rate determination theory, PPP is an important basis for other exchange rate theories and for calculation of the real valid exchange rate. The PPP is also used to determine whether a country's exchange rate misaligned. Although the PPP theory is very simple and the expression is intuitive, it has attracted a lot of attention since its birth. Many economists conducted a series of important research on it. Especially with progress and development of measurement techniques and mathematical economy, the PPP has gone through different stages of development. Early research technique was mainly the method of ordinary least squares, followed by the development of the stability test, and then Co-integration study , the use of cause- effect test, long period data, and panel data. So far certain consensus was also formed: in the long term the PPP is effective, but in the short term the exchange rate will fluctuate wildly.This paper proceeds from the basic theory of PPP, and then data from three countries (the USA, Japan and China) are selected, and a variety of measurement methods are used to verify whether the PPP works in china or not. After that we will go to discuss the use of the PPP in china and the issues that should be aware of. Furthermore, taking into account labor costs, trade barriers, capital flows and other factors, the thesis discusses the amendment and development of PPP. Finally the thesis concludes that: despite of many shortcomings, PPP to some extent, can guide the formation and direction of the RMB exchange rate and guarantee the future of RMB exchange rate to be reasonable and stable.