Exchange rate in Albania and the Purchasing Power Parity (PPP)

Abstract

The analyses and assessments of the international parity conditions are essential precursor to the monetary approach to the modelling of exchange rate determination.

Although, the PPP is of great relevance, a major defect of the PPP theory is that it does not hold for all types of goods and that it is just about goods arbitrage and says nothing about international capital movements. Nevertheless, despite this, PPP still has a role to play in exchange rate determination.

In the asset models of exchange rate determination, the interrelationship between the demand and supply of the specified assets determine exchange rates as the relative price of two currencies. The measurements of these relative prices is in terms of the relative demand for and supply of money. The assets model approach of exchange rate (with perfect capital mobility as basic assumption) can be broken down into two major categories: (i) monetary models approaches (with perfect capital substitutability as core assumption) and (ii) portfolio balance approaches (with imperfect market substitutability as core assumption). The monetary approach to exchange rate determination (which is direct outgrowth of the PPP theory and the quantitative theory of money) suggests that exchange rate is the relative price of two monies.

There seems to be a general perception that the exchange rate pass-through is the most important channel in the transmission process of monetary policy in Albania. This perception is questioned here in light of the altering relationships in this developing economy. A discussion on the transmission channels in the Albanian economy is followed by a study of the macro-economic relationships and pragmatic econometrics quantifying the monetary effectiveness. The results indicate that the dollar has become less important in the monetary transmission process at the benefit of the euro. There are moreover strong signs that the exchange rate channel as such is loosing its influence at the benefit of the other transmission channels, like the credit channel and most likely the wage channel.

However, economists have tested the PPP theory, pursuing criticisms on the accuracy of this paradigm vis-a-vis the long-run behaviour of the real exchange rate. Studies from Froot and Rogoff (1991) and MacDonald (1995) look at it from this perspective. Under continuous scrutiny, both theoretically and empirically, the PPP theory is generally understood to be able to, at best, determine the real exchange equilibrium only in the very long horizon, which typically overcomes relevant timeframes for economic policy and cannot provide an understanding of factors behind short and mid-term deviations from equilibrium.