A new approach to testing ex ante purchasing power parity

Abstract

Conventional PPP neglects the role of uncertainty and expectations in the determination of exchange rates. In the presence of uncertainty and expectations about the future, as postulated by ex ante PPP, the exchange rate is determined not only by current relative prices but also by the expected real exchange rate, implying that the omission of the latter makes the PPP model misspecified. Results of empirical testing indicate the importance of the role played by the expected real exchange rate in determining the current nominal exchange rate. These results support the ex ante PPP model against the conventional model.

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