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PURCHASING POWER PARITY (PPP) is one of the most important conditions in international finance because many models of exchange-rate determination are built on the assumption that it holds. l The PPP principle is crucial in understanding the nature of nominal as well as real disturbances in those models and is also widely used in policy deliberations, such as in the determination of target zones. The large and persistent deviations from PPP in the last two decades, however, have called it into question. It is now known that PPP, as an exact relationship, holds only under strict circumstances. Many real-life complications, such as the presence of transactions costs and trade frictions, differential baskets of goods used to construct aggregate price indices, and government policy interventions in foreign exchange markets, can make it fail. Indeed, early studies have reported evidence of significant short-run …