THE PPP THEORY OF INFLATION AND POST COLONIAL TRADE RELATIONSHIPS: THE CASE OF TWO AFRICAN COUNTRIES

Abstract

Using the absolute version of the Purchasing Power Parity(PPP) theory, the paper models the nominal exchange rate and the price level as integrated process that ensure that trade between two countries will render the real exchange rate as a stationary variables. After conducting a Unit Root Test on the primary price and exchange rate variables, the paper employs the Johansesen Cointegration technique, to investigate whether the current inflation differential accounts for the difference between the present and previous exchange rate levels for two pairs of countries: Cote d’ Ivoire and France, and Ghana and Britain, as well as between these two developing countries and two other developed countries, Japan and the US. Given the higher trading and financial relationship between the former two countries we expect a priori the PPP theory to yield more robust result here than in the latter case. The result is the reverse suggesting that indeed Ghana’s significantly higher average annual inflation rate is a stronger determinant of exchange rate than the two nations’ trading pattern. The implication is that even in the absence of any IMF inspired structural adjustment policies, the market will enforce the requisite change