Purchasing power parity and the Asian financial crisis: Implications for policy makers

Abstract

Purchasing power parity (PPP) literature is now vast with literally hundreds of papers offering tests for PPP across a large number of countries. However, despite all the elaborate techniques employed, very little explanation is given as to why PPP is so relevant in policy making. This article provides a basic understanding of PPP and shows why it is considered so important when making policy choices. The discussion also briefly examines how this relates to the Asian economies. Primarily, these economies have been subject to intense scrutiny following the 1997 crisis, particularly with regard to their choice of exchange rate regime and possible monetary unification. The findings of the paper suggests that the PPP has had mixed results in predicting current account difficulties and liquidity crises, such as that experienced in Asia. However, the paper also argues that it still can form an integral part of an ‘early warning system’ designed to foresee economic crisis within a country.