Military spending as another cause of the failure of the PPP

What is it about?

In a recent article, with a strong theoretical argument but poor empirical support, military spending was identified to be a determinant of real exchange rate or a factor causing the PPP to deviate from equilibrium exchange rate. The poor empirical results were mostly due to a small number of observations (21 cross-sectional). This article employs pooled data from across 37 developing countries over the 1985–1998 period and provides very strong empirical support for the notion that indeed increased military spending could cause the PPP to deviate from equilibrium exchange rate.

Featured Image

Why is it important?

Several factors have been identified as sources of deviation of the PPP-based exchange rate from equilibrium rate. These include trade restrictions, speculation in the foreign exchange market, higher expectation of inflation, real changes in the economy, long-term capital movements, government intervention, share of minerals in GDP as a measure of natural resource abundance, level of education, productivity differentials and corruption. Recently Bergstrand (1992) introduced a theoretical model in which he identified military spending as another determinant of the real exchange rate. Restricted to cross-sectional data from 21 countries, his empirical results were not significant enough to support the theoretical derivation. This article employed pooled data from 37 developing countries over the period 1985–1998 (for a total of 518 observations) and provided highly significant empirical results supporting Bergstrand’s theoretical arguments that an increase in military spending widens the gap between the PPP and the equilibrium exchange rate.

Perspectives