Bangladesh Development Studies Vol. XXXVI, March 2013, No. 1 Testing the Existence of Purchasing Power Parity in Bilateral Trade between Bangladesh and India SIRAJUL ISLAM*The paper uses the data of exchange rate and ratio of GDP deflators of Bangladesh and India covering the period 1971-2011 to justify the presence of Purchasing Power Parity (PPP) between the two countries. Unit roots test has been used to confirm the stationarity of the data. Cointegration test is used to verify the existence of a long-run relationship between exchange rate and the relative cost of bundles. While these two variables are not observed to be in equilibrium in the long run, Granger causality test finds no causal relationship between the two. This disequilibrium is further escalated due to the imposition of trade restrictions or other conditions affecting the bilateral trade relationship. These obstacles need to be addressed in order to ensure the stability of the exchange rate and maintain favourable trade relationship based on PPP. Keywords: Purchasing Power Parity, The Cost of Domestic Baskets, The Cost of Foreign Baskets, Cointegration JEL Classification:C32, C87, F14, F10 I. INTRODUCTION The Purchasing Power Parity (PPP) relationship becomes a theory of exchange rate determination with the introduction of assumptions about the behaviour of importers and exporters in response to changes in the relative costs of national market baskets. PPP is based on the perfect capital market structure. According to the law of one price, when the price of a good differs between two country's markets, then the profit-seeking individuals attempt to buy the good in the low price market and resell it in the high price market. Similarly, if a market basket, containing many different goods and services, costs more in one market than another, it is expected that profit-seeking individuals will buy the relatively cheaper goods in the low cost market and resell them in the higher priced market. *Lecturer in Economics, Department of Economics, Bangladesh University of Business and Technology (BUBT),Dhaka, Bangladesh.
Bangladesh Development Studies 122If the law of one price leads to the equalisation of the prices of a good between two markets, then it seems reasonable to conclude that PPP, describing the equality of market baskets across countries, should also hold (Suranovic 2006). Most of the developing countries like Bangladesh as well as the SAARC countries share some basic properties in determining the exchange rate, whereas the exchange rate determination is quite different in developed countries. The most focusing differences are mentioned below: i.The government intervention is higher in forex in the case of developing countries than the developed countries that sometimes leads to bid up or down of exchange rate from PPP.