International Journal of African and Asian Studies www.iiste.org ISSN 2409-6938 An International Peer-reviewed Journal Vol.6, 2015 37 Testing Purchasing Power Parity: A Comparison of Pakistan and India Muhammad Zulqarnain Asab Department of Management Sciences, The Islamia University of Bahawalpur E-mail: asabmuh@gmail.com Muhammad Abdullah Department of Management Sciences, The Islamia University of Bahawalpur E-mail: forever0022@yahoo.com Muhammad Nawaz (corresponding author) Department of Management Sciences, The Islamia University of Bahawalpur E-mail: muhammednawazmalik@gmail.com Muhammad Irfan Shakoor Department of Management Sciences, The Islamia University of Bahawalpur E-mail: irfan_shakoor@hotmail.com Usman Arshad Department of Management Sciences, The Islamia University of Bahawalpur E-mail: mr.usmaniiu@yahoo.com Abstract We defined the purchasing power parity (PPP) in the scenario of Pakistan and India as a long term unit elasticity of exchange rate and compared it with relative national prices. The characteristic of finite sample are analyzed through time series regression analysis. It allows the cross sectional dependency, country heterogeneity and non- stationary disorder. Because the deviation of PPP is decrease with very slow rate, we execute the test on the data of 43 years. The past studies have showed that data was collected on the basis decades, like some of the researcher data contained on 08, 35 and 55 years. Additionally using the time series regression, this study observed the structural changes over a long term period. In this study, result identifies that the real exchange rate of India and Pakistan are not constant. The practical evidence shows that long run PPP holds for the sample countries. Keywords: Purchasing Power Parity; Exchange rate; Time Series Regression Test; Relative National Prices 1. Introduction It is an economic theory which is being used for the compression of money at a comparatively stage as per value of the second country’s currency at the equivalent level of the each country purchasing power. The PPP can be calculated as: Where: "S" donates the exchange rate of currency (1) to currency (2) "P 1 " donates the cost of good (x) in currency (1) "P 2 " donates the cost of good (x) in currency (2) It is a simple theory which hold that the rate of exchange between two currencies must be equal to the ration aggregate price levels between two countries, in simple we can say that the a unit of home country must have the same value in the foreign country. Its means that the home currency has the same value of purchasing power in the foreign country as it is in home. According to the law of one price identical the same value of the money should be determined for the purchase and sale of products between two nations at the same time. If the two countries are producing the same products or substitute of these products, in such case demand of one product is fluctuate due the change of inflation in one country. The shifting of demand from Pakistan to India will be continued until the value of Indian rupees appreciated. Prices paid by Indian consumer for the Pakistani goods no lower than the comparable products and Prices paid by Pakistani consumer for Indian goods are no higher than the comparable goods. This equilibrium appreciate the Indian Rupees. Purchasing power parity (PPP) creates a relationship between movement of country’s inflation or deflation and foreign exchange rate relative to that of a foreign country (Coakley, Flood, Fuertes, & Taylor, 2005).Absolute PPP