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JOURNAL OF APPLIED BUSINESS AND ECONOMICS

Comparing Two Exchange Rate Regimes Under Purchasing Price Disparity

Author(s): Kishor K. Guru-Gharana, Deergha Adhikari, Jennifer L. Flanagan

Citation: Kishor K. Guru-Gharana, Deergha Adhikari, Jennifer L. Flanagan, (2011) "Comparing Two Exchange Rate Regimes Under Purchasing Price Disparity," Journal of Applied Business and Economics, Vol. 12, Iss. 2, pp.40 - 48

Article Type: Research paper

Publisher: North American Business Press

Abstract:

The theoretical and empirical literatures do not give a clear answer about the superiority of flexible

exchange rate regime over fixed exchange rate regime when purchasing power parity (PPP) condition

fails to hold. The flexible exchange rate regime is generally shown to be superior, assuming PPP. This

study is a fresh examination of the popular assertion that Flexible Exchange Rate regime outperforms

other Exchange Rate regimes. We analyze the effect of the violation of purchasing power parity combined

with deviations in output target and real exchange rate from their long-run equilibrium values on

government’s decision domain, which we call government’s loss function. This study uses a government

loss function, for the most part derived from Barrow and Gordon (1983), to compare two exchange rate

regimes under different PPP conditions. The results of this study confirm that a flexible exchange rate

system indeed performs better if PPP holds. However, this implication may not be true when PPP doesn’t

hold, even if the cost of exchange rate change is zero. A major finding of this study, in sharp contrast to

Obstfeld (1996), is that, if PPP does not hold, the flexible exchange rate system cannot be guaranteed to

perform better unless two additional conditions are met: (a) output target is fully adjusted to its long-run

equilibrium value; and (b) the long-run real exchange rate is lower than its long-run equilibrium value. If

these conditions are not met, the result is ambiguous. Since the above two conditions may not always

hold, the implication of this study is quite significant and offers the opportunity for future empirical

research.