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tistic of -3.039267. Comparing this t-statistics with the critical value taken from the Dickey- Fuller t-stats table (applied to residuals from spurious co-integrating regression) for Case 3 of -3.42, it can be inferred that the residual has a unit root and is non-stationary. (See table 5)

H0: PPP does not hold in the long run

H1: PPP hold in the long run

Consequently, this implied that the variables are not co-integrated and the null hypothesis that PPP does not hold in the long run equilibrium cannot be rejected.

4.3 Johansen Test Results

Table 6a and 6b shows the Johansen test results for the Trace and Maximum Eigenvalue test respectively. Each test examines two hypotheses;

H0: No Co-Integration

H1: One Co-Integrating Relationship

H0: One Co-Integrating Relationship

H1: Two Co-Integrating Relationship

The results from both tests show evidences that they reject the null hypothesis of no co-integration and cannot reject the null hypothesis of one co-integrating relationship. Therefore, this meant there is presence of one co-integrating relationship within the variables.

The Johansen test has shown that there exits a long-run equilibrium relationship between the exchange rate and the relative price levels of U.S and UK. But in the short run, there might be disequilibrium. In order to reconcile and explain the transition the short-run to long run equilibrium, I will employ the use of the error correction mechanism or Vector Error Correction (VEC). This process enables a proportion of the disequilibrium in one period to be corrected in the next period and help to explain the change in exchange rate to the change in relative price levels and previous period’s disequilibrium.

Table 7 presents the results from the Vector Error Correction (VEC) estimates. The partial short run adjustment coefficient shows how much the disequilibrium is “corrected” per month as the variables change. The adjustment coefficient for exchange rates is negative and insignificant, at 0.5% per month while the adjustment coefficient for the relative price levels of the countries is also negative and stands at 1.25% per month. This meant that all the “correction” of the disequilibrium in the short run is done by relative price levels instead of exchange rate.

5. Conclusion

Purchasing Power Parity (PPP) has generated considerable amount of interest from academia and interested parties (ie. Government, Central banks etc), since being formally introduced by Gustav Cassel in 1918 as it offers a basic theoretical model to exchange rate determination which is not just simple to understand and also intuitive for application. Since 1970s, academia has explored the PPP issue from varying perspectives and with the use of progressively advanced econometric techniques, but the results has not been consistent. In the midst of the mixed results, there is still belief that this theory holds the key to being an important manual for explaining the exchange rate differences between countries. This has lead to Dornbusch and Krugman (1976 p.540) declaring that “Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate”.

This paper joins the vast amount of existing literature by inves