Does the purchasing power parity fit for China?

Abstract

This paper aims to assess whether the purchasing power parity (PPP) holds by examining the dynamic link between nominal exchange rate (NER) and relative consumer price (RCP) in China. With economic transitions and structural changes existing, we discover that by using full sample data the PPP does not hold. Consequently, we apply the rolling window causality method in order to reconsider the dynamic causal link, and as a result we observe NER having both positive and negative impacts on RCP in some sub-periods. However, RCP has no effect on the NER, meaning that the PPP does not hold. Trade cost, restrictions and imperfect competition are considered in explaining the deviations in some sub-sample periods. Therefore, this empirical result has important implications for stakeholders to distinguish factors that bring about the PPP deviations and further offers policy suggestions for the Chinese monetary authority. ARTICLE HISTORYand Nian, (2016) assess the impact on exchange rates of inflation during the economic crisis. Therefore, the People's Bank of China (PBOC) chooses discreet monetary policies when decreasing the negative influence from deviations. The PPP condition between RCP and NER forward premiums or discounts does not only provide a basis for the evaluation of the effectiveness of monetary policy but offers as well suggestions to promote NER mechanism reform.Since 2005, China has experienced the following striking shocks both from inside and outside. The PBOC launched the reform of the RMB exchange rate regime by switching from the dollar peg to a basket of currencies in 2005:M07. Meanwhile, the PBOC also allow the bilateral exchange rates to float within a daily band from 0.3% to 2%. (Cui, 2015) indicates that the reform increases the flexibility of the RMB exchange rate. The effects of the global financial crisis are widespread, which obviously impacts on the Chinese economy, affecting exports and the NER and inducing the need for structural adjustments. The RMB is included in Special Drawing Rights (SDR) by the International Monetary Fund (IMF) in 2016 denoting a substantial progress in internationalisation and liberalisation of the RMB (Xu et al., 2015). All the incidents mentioned above may bring structural changes in the NER and result in the NER deviating from the PPP. Consequently, there is an imminent concern regarding whether the PPP still fits for China. If the PPP holds, the higher domestic inflation rate will result in a RMB exchange rate depreciation in the future. Meanwhile, keeping price stability is one of the main goals for the PBOC, which is greatly motivated to pursue an investigation, related to the PPP condition between the RCP and the NER in China. Combined with corresponding results, we provide suggestions for reforming the NER mechanism and implementing a discreet monetary policy.Substantial studies have been undertaken with focus on the PPP. However, the empirical researches have not reached a consensus on whether the PPP holds or not. Engel and Rogers (2004) argue that in a fle...

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