Pass-through of exchange rates and purchasing power parity

In this paper we develop and test two hypotheses about purchasing power parity (PPP). The first is that changes in the price of traded goods relative to domestic substitutes will affect the PPP relation, due to the partial pass-through of exchange rates. The second is that PPP should hold on forward rather than spot exchange rates, due to hedging by firms, which implies that the interest rate differential should enter the PPP relation for spot rates. Using quarterly data for several countries, we find support far both these hypotheses, though the magnitude of the interest rate effect is very small.