Purchasing-Power Parity
Purchasing-Power Parity
Purchasing-power parity (PPP) is the key theory that explains the rela-
tionships between currencies: In essence, it claims that a change in relative
inflation must result in a change in exchange rates in order to keep the prices
of goods in two countries fairly similar. Figure 8.1 illustrates this point. Ac-
cording to the PPP theory, if Japanese inflation, for example, were 3 percent
and U.S. inflation were 6 percent, we would expect the value of the dollar to
fall by the difference in the interest rates. That means that the dollar would be worth fewer yen than was the case before the adjustment, and the yen would be worth more dollars than before the adjustment.
The PPP theory is very useful in explaining the relationship between exchange rates, but it is not perfect. We need to make assumptions about the equilibrium exchange rate at a starting point and recognize that currencies are rarely related accurately in a two-country world. When several currencies are involved, it is difficult to use prices to determine an equilibrium rate. Also, exchange rates are essentially a function of traded goods, whereas inflation relates to all goods whether traded or not. Throughout the period since 1973, when the world essentially shifted to a floating-rate regime, those rates have not conformed to the PPP theory very accurately. In 1986, for example, the market exchange rate for the Japanese yen was 168 yen per dollar. However, the exchange rate equalized for PPP should have been 223, a difference of 24.2 percent. The West German mark was 12.5 percent weaker than it should
have been, and the British pound was 19.3 percent stronger than it should have been against the U.S. dollar.8 In 1990 the dollar/yen exchange rate fluctuated from a high of nearly 160 yen per dollar to a low of 120 yen per dollar, and yet comparative inflation did not change that much during the year. U.S. tourists also complained about how expensive it was to travel in Europe in comparison with the United States, demonstrating that purchasing-power differences existed in Europe and the United States. Finally, although relative rates of inflation may be helpful over the long run, there are many other factors that influence exchange rates, as will be seen below.
Purchasing-power parity (PPP) is the key theory that explains the rela-
tionships between currencies: In essence, it claims that a change in relative
inflation must result in a change in exchange rates in order to keep the prices
of goods in two countries fairly similar. Figure 8.1 illustrates this point. Ac-
cording to the PPP theory, if Japanese inflation, for example, were 3 percent
and U.S. inflation were 6 percent, we would expect the value of the dollar to
fall by the difference in the interest rates. That means that the dollar would be worth fewer yen than was the case before the adjustment, and the yen would be worth more dollars than before the adjustment.
The PPP theory is very useful in explaining the relationship between exchange rates, but it is not perfect. We need to make assumptions about the equilibrium exchange rate at a starting point and recognize that currencies are rarely related accurately in a two-country world. When several currencies are involved, it is difficult to use prices to determine an equilibrium rate. Also, exchange rates are essentially a function of traded goods, whereas inflation relates to all goods whether traded or not. Throughout the period since 1973, when the world essentially shifted to a floating-rate regime, those rates have not conformed to the PPP theory very accurately. In 1986, for example, the market exchange rate for the Japanese yen was 168 yen per dollar. However, the exchange rate equalized for PPP should have been 223, a difference of 24.2 percent. The West German mark was 12.5 percent weaker than it should
have been, and the British pound was 19.3 percent stronger than it should have been against the U.S. dollar.8 In 1990 the dollar/yen exchange rate fluctuated from a high of nearly 160 yen per dollar to a low of 120 yen per dollar, and yet comparative inflation did not change that much during the year. U.S. tourists also complained about how expensive it was to travel in Europe in comparison with the United States, demonstrating that purchasing-power differences existed in Europe and the United States. Finally, although relative rates of inflation may be helpful over the long run, there are many other factors that influence exchange rates, as will be seen below.
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