The paper attempts to examine the validity of the Purchasing Power Parity (PPP) hypothesis for Papua New Guinea (PNG) during the floating exchange rate regime. Exchange rates for the Australian dollar, Japanese yen, the UK pound and the US dollar in terms of kina are used in the empirical analysis. Two models—restricted and unrestricted—are used to investigate the validity of the PPP hypothesis. For the restricted model, Johansen cointegration test finds that there are long run relationships between the kina exchange rates for the Australian dollar, Japanese yen and the US dollar and the ratio of PNG price level to price levels of Australia, Japan and the US. The results for the unrestricted model indicate long run relationships between the kina exchange rates for all the four currencies and price level of PNG and those of the four countries. These results are consistent with the PPP hypothesis. However, results for any of the currencies do not support the symmetry and proportionality conditions implied by the PPP hypothesis.

The Purchasing Power Parity (PPP) which is the cornerstone of many of the theoretical models in international finance states that nominal exchange rates tend to adjust to those levels where the PPP of currencies remain constant over time. It is an important concept to the policymakers of the less developed countries for at least two reasons (Holmes, 2001a). First, PPP can be used as a model to predict exchange rates and determine whether a particular currency is overvalued or undervalued. Predicting exchange rates and determining whether a currency is overvalued or undervalued is particularly important for the less developed countries and those experiencing large differences between domestic and foreign inflation rates. Second, many theories of exchange rate determination use some notion of the PPP in their construction. Therefore, the validity of the PPP is of paramount importance to policymakers in developing countries who base their advice on the PPP (Liu and Burkett, 1995).

The companies that conduct business at the international level are often concerned with economic exposure. The economic exposure that results when a national currency deviates from its PPP level, affects the value of a firm. The managers of the firms engaged in international trade can use the concept of PPP to recognize economic exposure, and to make decisions to maintain the value of their firms. As far as the corporate foreign exchange dealers are concerned, they use trading rules to beat the market, and to obtain some gain. One such trading rule uses the PPP to identify whether a currency is overvalued or undervalued. Undervaluation or overvaluation of a currency occurs when its value differs from its PPP value.

Purchasing Power Parity of Papua New Guinea: A Cointegration Analysis,exchange, currency, countries, between, exposure, international, economic, undervalued, concept, policymakers, Purchasing, developed, Australian, developing, differences, domestic, cointegration, experiencing, importance, Guinea, consistent, investigate, market, managers, nominal, overvaluation, cornerstone, corporate