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the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate”. It was further pointed out by Rogoff (1996), that even with the mixed results from the various literatures, there was “a surprising degree of consensus on a couple of basis facts” First, the real exchange rate converges towards PPP in the long run although the speed is very slow. In addition, the disturbance from the short run equilibrium is normally large and volatile which prevent the determination of exchange rate in the short term. As a result of the deviation from PPP in the short run, the “Purchasing Power Parity Puzzle” is consequently presented to researchers and interested parties alike.

They have searched and investigated different aspect of PPP and improved their statistical approaches in the hope of explaining the deviations in the short run and how it could be reconciled with the long run exchange rates. In the earlier studies like Gailliot (1970), Lee (1976) and Friedman (1980), they have used a simple method of using the basic PPP relationship as the null hypothesis to test for the relevance of PPP. As expected due to the stringent criteria, most studies failed to find the validity of PPP in the long run. Surprisingly, Frenkel (1978) found that the PPP theory holds for countries undergoing hyper-inflation phase but was less successful for countries with stable economic conditions. With the unsuccessful attempts in the early days, researchers started to revisit the issue from another perspective by testing the null hypothesis that the real exchange rate does not revert to its mean but instead follows a random walk (Roll 1979; Darby 1983; Edison 1987 etc). Some techniques to test for unit root included the Dickey-Fuller and Augmented Dickey-Fuller test and Variance ratios. These techniques did not seem to improve the probability of rejecting the null hypothesis of random walk and that PPP holds in the long run. More recently, methodologies like co-integration and fractional integration & co-integration have entered the picture. Corbar and Ouliaris (1988), Taylor (1988), Kim (1990) applied co-integration techniques but most found that the null hypothesis of non co-integration cannot be rejected in most cases while Rogoff and Froot (1994) compared the 3 techniques used to determine PPP and concluded that although the co-integration test have been more successful in rejecting the null hypothesis, it is still unclear whether this technique produces a benefit over the simple PPP hypothesis or random walk test. On the other hand, Cheung and Lai (1993), Masih and Masih (1995) and Soofi (1998) employed the fractional integration approach and found relatively favourable results. Regardless of the mixed results from different methods and econometric techniques, purchasing power parity theory remains an important aspect in exchange rate determination as it is simple to comprehend and intuitive.

The objective of this paper is to investigate the relevance of the PPP theory on the exchange rate of two advanced economies, U.S and UK respectively. This analysis will be conducted using co-integration test, a common time series methodology in the PPP literature. Furthermore to ensure the robustness of the results, Johansen test will also be applied.

The rest of this paper is organised as follows; Section 2 presents the introduction of purchasing power parity and law of one pric