Testing the Purchasing Power Parity Theory in Economic Reality

This research paper attempts to test the applicability of the Purchasing Power Parity theory to the Algerian economy. Annual data from 1990 to 2023, specifically concerning the official exchange rate and the consumer price index, were used. By conducting a series of econometric tests, such as stationarity tests, cointegration tests, and causality studies, the study concludes that there is a long-term equilibrium relationship between the official exchange rate and the consumer price index. Hence, it can be inferred that the PPP theory holds true for the Algerian context. This implies that purchasing power parity is maintained in the long run, and therefore, this theory can be relied upon to determine and interpret the exchange rate of the Algerian dinar in the current scenario. The results of the error correction model estimation from the joint integration test also showed a direct relationship between the nominal exchange rate and the consumer price index, such that a relative change in the exchange rate by one unit leads to a relative change in the consumer price index by 0.14. The error correction model coefficient, estimated at 0.024, reveals the speed of the return to the equilibrium position and is a relatively weak correction coefficient. Based on the R² value, it can be said that exchange rates represent 69% of the changes in the consumer price index. The Granger causality test revealed a causal relationship running from the official exchange rate to the consumer price index for the Algerian economy.