The present study examines the trading patterns of Pakistan with its two major trading partners: China and the United Arab Emirates (UAE), through the application of purchasing power parity (PPP) theory. Purchasing Power Parity (PPP) is a theory of exchange rate determination and a way to compare the average price of goods and services between the countries. The theory assumes that the transactions undertaken by importers and exporters are motivated by the cross country price difference; which in turn induce changes in the bilateral exchange rate. The objective of the research paper is to assess the PPP theory behavior, in case of Pakistan, with its two major trading partners, i.e., whether the long-run movements in the exchange rate are affected by changes in the price level in the country. The study examines the PPP theory on the time series data from 1980 to 2013, through an application of the Ordinary Least Square (OLS) regression. The results indicate that in the case of China, PPP theory holds with Pakistan and the price level has a significant role to play. It induces changes in the exchange rate determining the long-run equilibrium path for trade between Pakistan and China. On the other hand, for UAE, the PPP theory does not hold with Pakistan, which might be due to productivity differences or fiscal shocks.
